Chapter 28 - Accepting risk

Question 1

What is a Risk Profile?

Answer 1

It is a complete description of the risk exposures of an organisation

Including future risks that will affect the current business of the organisation

Question 2

What is Risk limits?

Answer 2

this is a group of guidelines that set limits on acceptable actions that might be taken today.

If risk limits are adhered to, then each individual unit of the business should be deemed working within its permitted risk tolerances

Question 3

What is Risk capacity?

Answer 3

This is the volume of risk that an organisation can take as measured by some consistent measure, such as economic capital

Question 4

List features of a Company that might influence its risk appetite

Answer 4

LICE APPLES

Level of available capital
Institutional structure (mutual, proprietary)
Culture of the company
Existing exposure to a particular risk

Attitude to risk of owners and other providers of Capital
Period of time for which it has operated
Previous experience of board members
Level of regulatory control to which it is exposed
Existence of a parent company
Size of the company

Question 5

How might the board of a company express its appetite for risk

Answer 5

The board might express its appetite for risk with reference to:

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

Question 6

How does a ‘market for risk’ arise?

Answer 6

The fact that different entities have different appetites for risk enables a market for risk.
A market for risk exists if the price at which one party is happy to accept a risk is less than the perceived cost of the risk to a second party

Question 7

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

Answer 7

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

A risk efficient market is one of a reasonable size.

Question 8

Outline the ways in which risk and product design are related

Answer 8

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.
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 9

What 3 factors make a risk insurable?

Answer 9

1. The policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager.
2. The risk must be of a financial and reasonable quantifiable nature.
3. The amount payable in the event of a claim must bear some relationship to the financial loss incurred.

Question 10

Why do insurance companies aim to pool risk?

Answer 10

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 11

List 6 additional criteria that a risk should ideally meet to be insurable

Answer 11

I SLUMS

Individual risk Events should be independent of each other

Small probability of event occurring
Large numbers of potentially similar risks should be pooled in order to reduce variance and hence achieve more certainty
Ultimate limit on liability undertaken
Moral hazard eliminated as far as possible
Sufficient existing data to work with