Chapter 28: Accepting Risk

Question 1

Risk Appetite

Answer 1

A statement of the maximum amount and types of risk than an individual or organisation is prepared to take on, in order to meet their objectives

A clearly articulated risk appetite can be transferred into a desired risk profile for the organisation

Question 2

Risk Profile

Answer 2

A complete description of the risk exposures of an organisation, including risks that might emerge in the future and that will affect the current business of the organisation

Question 3

Risk limits

Answer 3

A group of guidelines that set limits on acceptable actions that might be taken today. If risk limits are adhere to, then each individual unit of the business should be deemed to be working within its permitted risk tolerances. Risk limits can be regarded as a component of risk capacity

Question 4

Risk Capacity

Answer 4

This is the volume of risk that an organisation can take as measured by some consistent measure, such as economic capital. If there is spare capacity, then it might be possible to take positive actions that add economic value to the organisation without breaching existing risk tolerances or risk limits

Question 5

List features of a company that might influence its risk appetite

Answer 5

1. Existing exposure to a particular risk
2. Culture of the company
3. Size of the company
4. Period of time for which it has operated
5. Level of available capital
6. Existence of a parent company / other guarantors
7. Level of regulatory control to which it exposed
8. Institutional structure (mutual, proprietary)
9. Previous experience of board members
10. Attitude to risk of owners and other providers of capital

Question 6

How the board may express its risk appetite

Answer 6

May relate risk appetite to:

• Solvency level
• Credit rating
• Earnings and ability to pay dividends
• Economic value

for example the solvency level should remain above threshold Y with 99.5% probability over the next 3 years

Question 7

Establishing risk tolerances and risk limits

Answer 7

The senior risk managers have the task of translating the higher level risk statements into a more detailed set of risk tolerances and risk limits across the enterprise

This needs to be carried out in a holistic way to take advantage of synergies and to avoid unanticipated concentrations of risk

A statement of risk tolerances needs to cover the company’s attitudes to all risks, both quantifiable and non-quantifiable (eg not hiring people with criminal records)

The statements of risk tolerance must be understood and easily implemented by all staff in the organization. In many cases this is done by establishing risk limits

Question 8

Risk metrices

Answer 8

Designed to measure whether the company is operating within its risk tolerance limits

Consists of quantitative and qualitative indicators of the level of risk in a specific part of the orginisation

Question 9

How does a ‘market for risk’ arise?

Answer 9

The fact that different entities have different appetites for risk enables there to be a market for risk, and for risk to be transferred from entities with a small risk appetite to those with a larger risk appetite.

Almost all financial transactions can be simplified down to a transfer of risk from one entity to another in exchange for a payment of money.

Question 10

What makes a market for risk transfer “risk efficient”?

Answer 10

“Where there is a good market for risk transfer”

A risk efficient market is one of a reasonable size normal economic factors will result in an efficient market

Participants with excess risk are able to transfer the excess to other participants who have less risk than they are prepared to accept.

Question 11

Give 2 examples of why the insurance company might not aim to make a profit when taking on an insured risk

Answer 11

• The company might be acting as a loss leader (in order to sell higher volumes of other products)
• The company might be insuring that risk because it diversifies against other risks already accepted, and does not need it to be profitable on a standalone basis

Question 12

Explain how investment in a CIS results in risk transfer

Answer 12

CISs allow individuals to transfer the risk of making poor investment decisions due to a lack of expertise or lack of time to perform research.

Question 13

Outline the ways in which risk and product design are related

Answer 13

1. Financial products transfer risk between parties
2. The price of a product needs to cover the cost of the risk being transferred and allow the party taking on the risk to make a profit.
3. The cost of risk relates not just to the features of that product but also on the other business of the provider (diversification, hedging)
4. Good product design techniques will identify all the risks involved in a product and consider how each is managed.
5. In order to determine an appropriate cost for a particular policy, it is necessary to perform risk classification (grouping).
6. There is a risk that a new product design does not meet the needs and desires of the beneficiaries.
7. Additional options (and other design complexities) introduce new risks, which need to be allowed for in the costing.

Question 14

What 3 factors make a risk insurable?

Answer 14

1. The policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager. (has to have an interest in the claim event not happening)
2. The risk must be of a financial and reasonably quantifiable nature. (the claim amount has to be able to compensate for the loss)
3. The amount payable in the event of a claim must bear some relationship to the financial loss incurred. (too high will encourage fraud and moral hazard, too low and purchase of insurance will not seem worthwile)

Question 15

Why do insurance companies aim to pool risk?

Answer 15

Pooling risk means that there is greater certainty in the future payments to be made on the occurrence of an insured event. This is due to the law of large numbers.

Question 16

List 6 additional criteria that a risk should ideally meet to be insurable (to reduce volatility by the law of large numbers)

Answer 16

SIP MUD

• Small probability of occurrence
• Independent risk events
• Pooling a large number of similar risks
• Moral hazard eliminated as far as possible
• Ultimate limit on liability undertaken
• Data exists with which to price risk

Question 17

Accumulations of risk

Answer 17

An accumulation of risk occurs when a portfolio of business contains a concentration of risks that might give rise to exceptionally large losses from a single event

Question 18

Self-insurance

Answer 18

The retention of risk by an individual or organization, as distinct from obtaining insurance cover