ERM Chapter 9

Question 1

What is a risk profile?

Answer 1

Complete description of the risk exposure of an organisation, including risks that might emerge in the future and that will affect the current business of the organisation.

Question 2

What is risk exposure?

Answer 2

The maximum loss that can be suffered if a risk event occurs

Question 3

What is the risk appetite?

Answer 3

Reflecting the setting of targets and limits across the organisation as a whole, plus a breakdown of these high level statements into more detailed risk tolerances

Question 4

What is risk tolerance?

Answer 4

A more detailed set of statements, many quantitative or statistical in nature. The statements may apply to specific categories of risk and/or units of business.

Question 5

What are risk limits?

Answer 5

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 business should be deemed to be working within its permitted risk tolerances.

Question 6

What is the risk capacity?

Answer 6

The volume of risk an organisation can take as measured by come 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 7

What is a utility function?

Answer 7

A measure of happiness or satisfaction as a function of wealth.

Realistic utility functions are:

• monotonically increasing (having more of something is better)
• concave (the amount of marginal utility decreases with marginal increases in wealth I.e. people are risk averse)

Question 8

What are three common utility functions and their key features?

Answer 8

Quadratic:

• maximise expected wealth subject to volatility
• increasing absolute and relative risk aversion

Exponential:

• constant absolute risk aversion
• increasing relative risk aversion

Power:

• decreasing absolute risk aversion
• constant relative risk aversion

Question 9

What are the formulas for absolute and relative risk aversion?

Answer 9

Absolute risk aversion:
-u’’(W)/u’(W) > 0

Relative risk aversion:
W x a(W)

Question 10

What is the main reason the power utility function may be more attractive than the other two?

Answer 10

The increasing absolute risk aversion implies that an investor that experiences an increase in wealth will choose the decrease the nominal amount invested in the risk asset/s. In reality, an investor experiencing increases in wealth will keep their portfolio unchanged, as suggested by the power function’s constant relative risk aversion.

Question 11

What are the features of the prospect function, and why is it a more attractive expression of risk tolerance than utility functions?

Answer 11

S-shaped, where above some reference point the curve is concave, and below is convex.

The prospect function considers the investors starting point for their wealth and is more realistic as to how investors would behave - decision makers tend to be risk seeking when facing losses and risk averse when facing gains. At either end of the curve it flattens, reflecting ambivalence to additions gains and losses in wealth when the level of wealth is extreme.

Question 12

Outline the main three sections of a risk management policy.

Answer 12

Objectives and definitions:

• the aims of the ERM activities e.g. how it links to the company’s objectives and strategy, benefits, success criteria
• a statement as to the company’s philosophy to risk management and desired risk culture
• risk categories and definitions (taxonomy)

Risk management structure:

• the role of risk managers e.g. CEO, CRO, executive managers, risk sponsors, risk owners, risk committee members
• the structure of corporate governance e.g. committee roles, delineation of accountabilities

Risk management processes and benchmarks:

• an overview of each stage of the risk management process
• risk appetite and tolerance statements
• risk policy standards, to ensure risk policies are consistent across the organisation

Question 13

What is the risk management policy?

Answer 13

Sets out how the organisation will manage each category of risk to which it is exposed.

It should include:

• objectives and definitions
• risk management structure
• risk management processes and benchmarks

The policy will generally cover a similar time period to that of the company’s business plans (3-5 years) and should be reviewed at least annually.

Question 14

Outline some key features of a risk appetite.

Answer 14

• a company’s risk appetite will reflect its capacity to absorb risk, which is affected by its objectives and culture, the current overall business environment, and how successful the company is currently. This involves considering the types and level of risks that are desired to meet objectives, and the risk tolerance of the company.
• a clearly articulated risk appetite can be translated into a desired risk profile.
• the boards expression of risk appetite can be performed with reference to the company’s solvency level, credit rating, earning and ability to pay dividends, and economic value. Usually these quantities will be referenced over a time period, and with a designated probability e.g. “the solvency level X should stay above the threshold Y with 99.5% probability over the next 3 years”

Question 15

Outline risk tolerance statements.

Answer 15

Translation of higher level risk appetite statements into more detailed sets. Describing the level of risk that an insurer is willing to take, these statements cover both quantifiable and unquantifiable risks.

Question 16

Outline risk limits.

Answer 16

Translation of risk tolerance statements into statements that are easily understood and implemented by all staff within the organisation.

Question 17

What are the equations of the three utility functions?

Answer 17

Quadratic:

u(W) = aW - (1/2) x W^2

Exponential:

u(W) = -exp(-aW)/a

Power:

u(W) = W^(1-a)/(1-a), a>0, a=/1
u(W) = ln(W), a = 1