ERM Chapter 26

Question 1

How can RM optimise the risk/return profile of an organisation?

Answer 1

• Supporting selective growth of the business:
  > establish a process for assessing new job opportunities. This process should include assessment of the risk adjusted return
  > allocate capital and other resources to BU’s or activities with high risk-adjusted return
• Supporting profitability through risk-adjusted pricing:
  > prices should reflect the cost of risk in addition to funding costs and operational expenses
  > NPV and EVA do not fully reflect the cost of risk, usually being based on book values of capital
• Using limit setting to control the size and probability of potential losses:
  > set basic exposure limits
  > set stop limits
  > set sensitivity limits
• Employing techniques to manage existing risks:
  > active portfolio management
  > reduce risk
  > transfer risks to a third party

Question 2

Outline five fundamental concepts in the management of a portfolio of risks.

Answer 2

1. Risk - typically expressed as the standard deviation of returns
2. Reward - usually expressed as the expected return on investment
3. Diversification - reducing overall risk by investing in many different projects or assets whose returns are not perfectly correlated
4. Leverage - borrowing money and investing it, thereby increasing the potential risk and return profile of the overall portfolio
5. Hedging - entering into an agreement which reduces risk, usually because the position taken is negatively correlated with the organisation’s existing position

Question 3

Outline several measures of risk-adjusted return.

Answer 3

1. RAROC = risk-adjusted return/capital

2. Sharpe Ratio = (Rp - rf)/op,
where Rp = return on portfolio
rf = risk free return
op = standard deviation of portfolio
- it measures out-performance compared to the riskiness of the portfolio

3. Other risk measures:
   - RARAA = net income / risk-adjusted assets
   - RAROA = risk-adjusted return / assets
   - RORAC = net income / capital OR net income / VaR
   - RARORA = risk-adjusted return / risk-adjusted assets

Question 4

Outline Mean Variance Portfolio Theory.

Answer 4

• it can be extended to any portfolio of risks e.g. an organisation’s projects
• states that the optimal combination of risky assets can be determined without any knowledge of the investor’s preference towards risk and return (the separation theorem)
• states that the investors’ choice from the set of efficient frontiers will be determined by their risk appetite, or equivalently, their utility function

Question 5

What are the four benefits of portfolio management in ERM, and explain how they can aid optimisation of risk-reward.

Answer 5

1. It encourages companies to ‘unbundle’ the business into component projects.
   - enables management to decide how to treat each project e.g. retain it unchanged, increase/decrease investment in the project, transfer some risk
   - may encourage companies to think about where they add value or can best compete, then focus on that risk area by transferring other risks to those who can manage them more efficiently
2. It provides a mechanism for aggregating risks across the whole organisation.
   - is useful for more transparent reporting and information purposes
   - enables transfer of some or all risks to a central team. This allows a specialist team to hedge or otherwise manage the risk. In addition, the BU’s are charged a price for transferring the risks to the CRF and the risk-adjusted profitability of the BU’s can be assessed.
3. It provides a framework in which risk concentration limits and asset allocation targets can be set.
   - risk concentration limits and asset allocation targets which operate together to achieve the orgnisation’s desired risk/return profile
   - risk concentration limits that impose a minimum level of diversification for the portfolio
   - asset allocation targets which aim to ensure most emphasis or resource is allocated to the most promising opportunities/projects
4. It influences investment, transfer pricing and capital allocation decisions.
   - an organisation can vary the price it charges a BU to transfer a particular risk to the CRF so influencing that unit to expand/contract in that area
   - having identified the risk/return characteristics of the organisation’s projects, management can allocate most capital to those expected to deliver the highest risk-adjusted returns
   - the market value of an organisation is influenced not only by the products it is selling now, but those in the pipeline
   - the MPT highlights the importance of diversification as a means of reducing risk without necessarily reducing expected return. Therefore MPT encourages organisations to invest in their pipeline projects as well as a range of products that are currently generating revenue

Question 6

What are the four types of risk responses?

Answer 6

1. Risk removal
2. Risk retention
3. Risk transfer
4. Risk reduction

Question 7

What are the key features of a good risk response?

Answer 7

• economical - cost of implementation should not exceed the reduction in risk
• well matched to the risk - to avoid introducing basis risk
• simple - to avoid making mistakes in executing the response
• active - the response should not simply inform, but also instigate action
• flexible and dynamic - reacting to changing circumstances

Question 8

What is risk transfer, and how can it be achieved?

Answer 8

Risk transfer involves passing the risk in question to another organisation, or another part of the same organisation.

Can be achieved through:

• insurance
• reinsurance
• co-insurance
• sharing the risk with a policyholder via product design
• securitisation
• purchase of some form of derivative
• ART products
• outsourcing

Other features of risk transfer include:

• a cost over and above the expected loss, as payment to the party whom the risk is being transferred in order to accept that risk and potentially contribute to profit. Although risk transfer usually removes the upside risk associated with the cost, it may be maintained through special transfer designs at an additional cost.
• risk transfer by definition involves a third party, and therefore introduces counterparty risk. Regulation my mitigate counterparty risk by setting a maximum amount permissible to transfer to a single counterparty. There also may not be enough capacity in the market to transfer the quantity of risk desired.

Question 9

What is risk reduction, and how can it be achieved?

Answer 9

Risk reduction, also known as RM, treatment or mitigation, generally refers to the reduction in the likelihood or severity of a risk.

Risk reduction can be achieved as follows:

• risks can be diversified by taking on uncorrelated risks. Diversification can occur across types of products, socio-economic status of customers, geographic region, sectors etc.
• random fluctuation risk can be reduced by increasing the size of the portfolio e.g. more insurance policies sold
• some risks can be partially hedged by taking on risks with opposite characteristics e.g. selling insurance products with mortality risk and longevity risk
• greater matching of assets and liabilities
• operational risks reduced by implementation of strong internal controls and governance
• underwriting and pricing risks reduced through robust underwriting practices and intelligent data analysis
• credit and counterparty risk reduced through robust due diligence practices and ensuring agreements are tightly worded
• reduce agency risk through intelligent remuneration and bonus systems that align better the interests of different stakeholders
• reduce solvency or wind-up risk through increased capital or funding

Question 10

What is risk removal, and what factors should be considered prior to removing a risk?

Answer 10

Risk removal is the process of getting rid of a risk entirely.

Prior to removing a risk, organisations should consider:

• the cost of removing the risk
• the impact of removing the risk on the likelihood of the project meeting its original objective
• whether any opportunities will be lost as a result of removing the risk

Question 11

What is risk retention, and under what circumstances may an organisation retain risk?

Answer 11

Risk retention is the process of absorbing risk, accepting risk or tolerating risk.

An organisation may retain risk if:

• the taking of that particular risk is a component of its core business
• it appears to be the most economical approach - it can be expensive to document and settle small losses, especially when management time is considered
• it acts differently to another risk that is retained
• there is no alternative e.g. nobody to transfer it to, or the risk may be uninsurable

Question 12

What are residual risks?

Answer 12

Residual risks are risks that remain due to:

• a decision made to retain them
• the result of a risk response action e.g. counterparty risk
• the result of an imperfect hedge

For those that cannot be insured or hedged against, risk capital should be held in order to mitigate their impact.

Question 13

What is alternative risk transfer (ART)?

Answer 13

• non-traditional risk transfer products which often combine features of both insurance and derivatives
• can be divided into two main categories:
  > vehicles based on capital market instruments
  > other unconventional vehicles used to cover conventional risks

A:

• improved organisational focus - allows the company to transfer risks to other parties and help them better focus on their core business and maximise capital efficiency
• customisation and timing - usually customised and designed to the organisation in question, enabling the nature and level of cover it wants. Some ART products can provide capital faster than more traditional approaches, and at the precise time it is needed.
• cost reduction and simplified admin - multi-line policy generally costs less than a series of policies, due to natural hedges or lack of correlation. Reducing the number of single policies reduces the administrative burden.
• earnings stability - an ART product can cover multiple types of risk and provide cover for extended periods of time, enabling smooth earnings.
• marking-to-market - capital market risk transfer establishes a market-based price for the risks being transferred

D:

• higher initial costs than traditional products
• more complex than traditional products, increasing the time and cost of developing a solution for an organisation
• an organisation may need to change the way it assesses and manages risk in order to gain maximum benefit from ART
• staff need to be educated about ART so they can understand the product, assess any seller of ART products, and appreciate the impact of regulation and accounting standards.
• demand expected to increase in the future, particularly if:
  > traditional insurance becomes more expensive, highlighting the savings offered by multi-line policies due to risk diversification
  > ERM becomes more widespread, allowing greater appreciation for risk transfer mechanisms
  > it becomes widely recognised that companies should focus on their core business and eliminate or transfer other risks