Chapter 26: Risk Identification and Classification

Question 1

Risk identification

Answer 1

Risk identification is the recognition of the risks that can threaten an organisation’s business plan

For each risk identified it is necessary to determine any risk control processes than can be put in place which will reduce either the likelihood of the risk event occurring or the impact of the risk event should it occur

It is also important to identify opportunities to exploit risks and gain a competitive advantage over other providers. Taking on risk is a potential source of profit if the risk is priced correctly

Identifying all the risks in an organisation is a difficult task and requires good knowledge of

• the circumstances of the organisation concerned
• the features of the business environment in which it operates
• the general business and regulatory environment

Question 2

Techniques available to ensure that all relevant risks have been identified

Answer 2

• Use risk classification
• Use techniques from project management (q3)
• Use risk checklists, as used for regulatory purposes
• Use the experience of staff who have joined from similar organisations, and of consultants with broad experience of the industry concerned

Question 3

Outline 5 methods of identifying the risks associated with a project

Answer 3

1. High level preliminary risk analysis to confirm that the project does not have such a high-risk profile that it is not worth analysing further
2. Brainstorming with project experts and senior internal and external people to:
   - identify likely and unlikely project risks, and their
   upsides and downsides
   - discuss these risks and their interdependency
   - broadly evaluate the frequency and severity of each risk
   - generate and discuss initial mitigation options
3. Desktop analysis to supplement brainstorming, which involves looking at similar projects undertaken by the sponsor and others in the past.
4. Consult with experts who are familiar with the details of the project and outline the plans for financing it.
5. Set out a risk register or risk matrix setting out risks and their interdependencies

Question 4

Suggest 7 categories of risks that could be used in a risk matrix for a typical project

Answer 4

1. Political - opposition to project, war, terrorism, etc
2. Natural - earthquakes, hurricanes
3. Economic - interest rate or exchange rate movements
4. Financial - sponsor default, incorrect cashflow estimates
5. Crime - fraud, theft
6. Project - time delays, budget overruns, bad design
7. Business - competition/lack of demand, operational problems

Question 5

Market risk

Answer 5

The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation

Examples:

• Change in interest rates / inflation
• Market crashes
• Mismatch of assets and liabilities
• Currency risk

Question 6

Outline 3 subdivisions of market risk

Answer 6

1. The consequences of changes in asset values (due to changes in the market value of assets or changes in interest and inflation rates)
2. The consequences of a change in investment market values on liability values, where liabilities are directly related to investment market values, interest rates or inflation rates.
3. The consequences of not matching assets and liability cashflows

Question 7

Do Question on bottom page 9

Answer 7

DO IT

Question 8

Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.
Give reasons why a perfect match may not be possible in practice.

Answer 8

1. There may not be a wide enough range of assets available; in particular it may may not be possible to find assets in sufficiently long duration.
2. Liabilities may be uncertain in amount and timing
3. Liabilities may include options and hence have uncertain cashflows after the option date.
4. Liabilities may include discretionary benefits
5. The cost of maintaining a full-matched portfolio is likely to be prohibitive.

Question 9

Credit Risk

Answer 9

The risk of failure of third parties to meet their obligations

Question 9

Credit Spread and why credit spreads may change over time

Answer 9

Credit spread is the difference in yield between a particular corporate bond and an otherwise equivalent government bond

Reasons for change:

• Perceived changes in quality of the issuers
• Market may alter its view on the premium for illiquidity that is placed on corporate bonds in general
• Perceived security of a type of bond may change

Question 10

What is a credit rating?

Answer 10

A credit rating is a rating given to a company’s debt by a credit-rating agency as an indication of the likelihood of default / credit-loss (creditworthiness)

Question 11

Outline 4 factors that an investor should consider when assessing the security of a debt and the borrower

Answer 11

1. The nature of the debt
2. The covenant of the borrower (e.g. credit rating, income and asset cover, level of gearing, prior ranking debt)
3. Market circumstances and the relative negotiating strength of borrower and lender.
4. What security is available and whether it can be realized if necessary

Question 12

Liquidity Risk

Answer 12

The risk that the individual or company, although solvent, does not have sufficient capital available to enable it to meet its obligations as they fall due.

The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets

Question 13

Define the term liquid asset.

Answer 13

A liquid asset is one that either:

• is close to cash in nature, or
• can be converted to cash quickly and the amount of cash it would become is almost certain

Question 14

What makes a market liquid

Answer 14

A liquid market is likely to be a large market with lots of ready participants.

(A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain)

Question 15

Why are banks exposed to significant liquidity risk?

Answer 15

Banks lend depositors’ funds and funds raised from the money markets to other organizations for potentially long periods.

Customers may want instant access to their deposits, creating a need for liquidity.

There is a risk that more customers than expected demand cash, because of:

• concerns about the bank’s security
• solvency concerns about one bank leading to heightened concerns about the solvency of other banks (aka contagion)

Question 16

Business risk

Answer 16

Risk specific to the business undertaken

Question 17

Outline 4 examples of business risks to a financial provider

Answer 17

1. Underwriting Risk - Inadequate underwriting standards leading to the mis-pricing of risks
2. Insurance Risk - More claims than anticipated or higher claim amounts than expected
3. Financing Risk - Investment in a business or project that fails to be successful (Financing of other projects)
4. Exposure Risk - Greater exposure than planned to a particular risk event. - related to amount of business sold or retained, concentration risk, lack of diversification

More examples p 19

Question 18

Operational risk

Answer 18

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Relates to non-financial events that have financial consequences

Question 19

Outline 4 examples of operational risk

Answer 19

1. Inadequate or failed internal processes, people or systems, for example
   - mismanagement
   - data errors
   - inadequate risk control measures
   - fraud
2. The dominance of a single individual over the running of a business (dominance risk)
   - can leave company/die
   - difficult to have good corporate governance / need to seperate powers
3. Reliance on third parties to carry out various functions for which the organization is responsible, e.g. outsourcing admin or investment
4. The failure of recovery plans following an external event

Question 20

How are operational risks likely to be identified and analyzed?

Answer 20

A model could be used but such models are only as good as the parameters input.

Identification and analysis of operational risks typically requires considerable input from the owners of a business, senior management and other individuals with a good working knowledge of the business.