Chapter 28: Accepting risk

Question 1

List features of a company that might influence its risk appetite.

Answer 1

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 2

How does a ‘market for risk’ arise?

Answer 2

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 3

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

Answer 3

A risk efficient market is one of a reasonable size.

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

Question 4

Explain how investment in a CIS results in risk transfer.

Answer 4

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 5

Outline the ways in which risk and product design are related.

Answer 5

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

Question 6

What 3 factors make a risk insurable?

Answer 6

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 the
   the financial loss incurred.

Question 7

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

Answer 7

MUD PIS

1. Individual risks should be INDPENDENT.
2. There should be a SMALL PROBABILITY
   of the event occurring.
3. Large numbers of similar risks should be
   POOLED to reduce variance.
4. There should be a limit on ULTIMATE
   LIABILITY undertaken.
5. MORAL HAZARD should be eliminated as
   far as possible.
6. There should be sufficient existing DATA /
   information in order to quantify risk.

Question 8

Why do insurance companies aim to pool risk?

Answer 8

Pooling risk means that there is greater certainty (lower volatility) in the future payments to be made on the occurrence of an insured event. This is due to the law of large numbers, which implies that actual results are increasingly likely to be close to expected results.

Question 9

Self-insurance

Answer 9

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

Question 10

Accumulation of risk

Answer 10

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.