1
Q
Definition of agency risk
A
Risk of loss due to an agent pursuing their own interests instead of the interests of the principal as they should. The costs that arise are called agency costs
2
Q
How to manage agency risk
A
Adjust remuneration to incentivize the desired behaviors
3
Q
Give examples of agents acting on behalf of principals
A
1) Directors and employees acting on behalf of shareholders and policyholders
2) Internal auditors acting on behalf of directors and shareholders
3) Investment managers acting on behalf of clients
4
Q
Definition of basis risk
A
A type of market risk. Risk that the price of an asset and an associated derivative do not move together as expected, exposing the company to variation and possibly nullifying intended hedging benefits
5
Q
Definition of biometric risk
A
Mortality, morbidity, and longevity risk
6
Q
Definition of business risk
A
Risks that are willingly taken on to create a competitive advantage and to add shareholder value
7
Q
Sources of business risk
A
Changes in market share, pricing margins, cost management, and the competitive environment
8
Q
Impacts of business risk
A
1) Annual financial and operating results may not meet management and stakeholder expectations
2) Revenue may not cover costs within a given period of time
9
Q
Definition of business volume and mix risk
A
Risk that the volume and/or mix of new business is materially different than expected. This causes a materially different capital position.
10
Q
Why is business volume and mix risk important?
A
This risk can cause a materially different capital position.
If sales are low, the insurer may not be able to cover expenses.
If sales are high, there could be severe capital strain.
Unexpected business mix could shift the risk profile.
11
Q
What are some sources of low sales?
A
Reputation damage, credit rating downgrade, new or strengthened competitors, changes in the economic environment or tax laws, loss of a key distributor
12
Q
What are some sources of high sales?
A
Unexpected success (beating previously stronger competitors), exit of a competitor from the market, tightening of product features or increased prices from competitors, change in reinsurance such that risk retention is higher on new business
13
Q
What are some sources of business mix risk?
A
Lower sales than expected for some products, higher for others. Unexpected lapses impacting some products more than others.
14
Q
What are some impacts of low sales?
A
Poor coverage of maintenance expenses, adverse claims experience on remaining business, and high lapses
15
Q
What are some impacts of high sales?
A
Capital strain, problems managing underwriting and expenses. Especially if sales are driven by older products, claims experience may end up being quite different than expected in the future.
16
Q
What to do about low sales
A
- Review remuneration for agents and brokers
- Diversify into multiple lines of business
- Control fixed expenses
- Maintain contingency action plans
17
Q
What to do about high sales
A
- Put capital-raising plans in place (with a parent company or external source)
- Improve operational readiness to handle increased volumes of business
- Review rates and underwriting guidance
- Review the use of reinsurance to mitigate the need for additional capital
- Withdraw a product or line of business
18
Q
Definition of catastrophe risk
A
- Risk that arises from single, unlikely, major incidents
- An element of operational risk
19
Q
How to manage catastrophe risk
A
- If possible, reduce frequency and severity of the risk (like reinsurance and location diversification)
- Monitor the environment for early warning signs
- Prepare an action plan
20
Q
How to manage an action plan
A
- Prepare details for different levels of severity
- Maintain and update the action plan
- Run role-playing simulations to ensure the action plan works and is well understood by key players
- If implementing the action plan, dynamically adjust the response throughout the crisis
21
Q
Definition of climate risk
A
Risks that arise from climate change, especially:
- Physical Risk: the risk of loss due to increased frequency and severity of climate events and
- Transition Risk: the risk of loss due to the transition to a lower carbon footprint economy
22
Q
Why is climate risk important
A
- Global wealth will be diverted to managing environmental changes
- Political instability is likely
- Essential infrastructure is highly vulnerable
- Natural resources will be depleted
- Increased likelihood and severity of hurricanes, wildfires, droughts, and desertification
- Increased likelihood of pandemics and infectious disease
23
Q
What are some impacts of climate risks
A
1) Legal risk, regulatory risk, and reputational risk if firms fail to follow environmental laws, regulations, and best practices
2) Increase in mortality and morbidity
3) Increased lapses and decreased new business
4) Increased cost of climate change adaptation leading to credit, market, liquidity, and expense risk
24
Q
How to manage climate risk
A
1) Adjust investment strategies. Look for opportunities like renewable energy.
2) Review concentration risk and diversify lines of business and geographic locations
3) Review types of products offered
25
Definition of compliance risk
The risk that the firm will violate laws and regulations (legal risk and regulatory risk)
26
Definition of concentration risk
Risk of increased exposure to losses due to a concentration of investment in a risk category, a product line, a distribution channel, an asset class, a geographical area, or other. Concentration risk amplifies other risks
27
Definition of counterparty risk
Risk that a counterparty in an over-the-counter financial contract (like interest rate swap or forward contract) will default. A form of credit risk.
28
How to manage counterparty risk
1. Netting: contracts with positive values are offset by negative values of other contracts
2. Collateral
3. Central Counterparties (CCPs): an institution that acts as an intermediary in a derivative transaction
29
What's the difference between credit risk and counterparty risk?
Counterparty risk is bilateral because both parties bear some risk. In traditional credit risk, only the lender assumes the risk
30
Definition of culture risk
A form of operational risk. Risk that a firm's Risk Culture negatively impacts the firm. Ex: a company culture of inflexibility leaves the firm vulnerable to rapid business environment changes
31
Definition of emerging risk
Risk that is developing or changing, is difficult to quantify, and may have a major impact. Often associated with a high degree of uncertainty, a lack of data, and are beyond the firm's control like climate change and some cyber risk.
32
Definition of equity risk
The risk of loss associated with exposure to an adverse movement in equity prices. A form of market risk.
33
Definition of expense risk
Risk of unexpected adverse expense experience
34
Sources of expense risk
New business, litigation, inflation increasing costs, technology risks especially after a cyber attack, mergers and acquisitions may not bring as much expense reduction as expected, and the performance of related companies in an enterprise may mean changes in the expense allocation throughout the enterprise
35
Definition of foreign exchange risk
Risk that the relative changes in currency values:
- decrease the value of foreign assets or
- increase the value of obligations denominated in foreign currencies
36
What are the components of foreign exchange risk?
1. Transaction risk
2. Economic risk
3. Translation risk
37
As a component of foreign exchange risk, what is transaction risk?
Risk that arises when a firm has current contractual obligations in a foreign currency
38
As a component of foreign exchange risk, what is economic risk?
General economic exposure to exchange rate fluctuations.
- Firms that import or export goods
- Firms that invest in foreign markets
- Firms whose good experiences demand slumps when exchange rate movements make imported competitive goods relatively cheaper
39
As a component of foreign exchange risk, what is translation risk?
Risk that arises from the requirements of financial reporting for a firm with assets and liabilities designated in different currencies.
Ex: A foreign subsidiary might show significant volatility in net assets between reporting periods due to exchange rate movements even if the value has been stable in the subsidiary's home currency
40
Definition of funding risk
The risk that positions may be profitable in the long run, but bankrupt a company in the short run
41
Definition of inflation risk
Risk of reduction in returns due to falling purchasing power
42
Why is inflation risk important
If incoming net CFs are fixed in monetary terms, the impact of inflation reduces their value and therefore, the real return.
Long-term, fixed amount CFs are most vulnerable.
Anticipated inflation is not a concern as it can be prepared for and managed. Even unanticipated inflation is not a concern if cash flows move in parallel, maintaining the real returns.
43
Impacts of inflation risk
Changes in foreign exchange rates (home currency value falls), increase in interest rates, increase in morbidity
44
How to manage inflation risk
- Implement rate increases
- Review the extent of the coverage and cost containment features
- Review the asset mix to increase real rates of return
- Review policies, procedures, and staffing to control costs
45
Definition of inherent risk
The natural level of risk inherent in a process or activity without doing anything to reduce the likelihood or mitigate the severity
46
Definition of lapse risk
Risk of loss due to unexpected lapse experience
47
Sources of lapse risk
- Changes to the firms products and reputation
- Changes to competitor's products
- Changes in the economic environment and policyholders' need for insurance
- Misestimation of expected experience
48
Impacts of lapse risk
- Anit-selection lapse causing worsened mortality and morbidity in the cohort remaining
- Mismatch of asset and liability cash flows
- Increased unit expenses
- Worsened liquidity (like a run on the bank)
- unexpected shift to less profitable or more capital-intensive mix of business
49
How to manage lapse risk
- For adjustable products, change premiums and/or benefits
- Adjust the price of new business
- Seek reinsurance solutions
50
Definition of legal risk
The risk of fines, penalties, and punitive damages from supervisory actions, lawsuits, or private settlements.
This includes risk of loss from unsuccessful lawsuits the firm files.
51
Sources of legal risk
1. Risk of lawsuit (employee health and safety, civil liability, etc)
2. Defective contracts
3. Failure to protect assets (physical or intellectual property)
52
Impacts of legal risk
- damaged reputation
- rating downgrade
- lower sales
- higher lapses
53
How to manage legal risk
- Have the legal counsel, risk management, and senior management work together to create company policies, and make sure agreements with counterparties can be enforced
- Improve disclosure transparency. Regularly review and update the disclosure practices to maintain compliance with laws and regulations.
54
Definition of liquidity risk
The risk that a company cannot raise cash to meet its obligations in a timely and cost effective manner due to insufficient liquid assets
55
Sources of liquidity risk
- High lapses and low new business
- Deterioration of the economy
56
What are the components of liquidity risk
1. Market liquidity risk (or asset liquidity risk): Risk that market conditions restrict access to liquidity, so transactions can't be conducted at normal market prices.
Ex: In a volatile, falling market, the cost of borrowing may be very high and the value of assets may be very low since there are so few buyers in the market.
2. Funding liquidity risk: Risk that early liquidation of assets is required to meet payment obligations, resulting in realized losses
57
How to manage liquidity risk
Set limits on cash flow gaps and diversify
58
Definition of maturity risk
The risk that demographic shifts cause risk profile shifts such that the firm is unable to bear the risks required to achieve its objectives. Important for pension plans.
59
Definition of model risk
The risk that inappropriate conclusions and decisions are made from model results due to issues in the model itself or the way it was used. A form of operational risk
60
Components of model risk
1. Defective model risk.
Model errors
Right model, wrong parameters
User generated errors (after installation)
Data quality issues
Inconsistent models
2. Defective model application risk
Right model, wrong application
Poor communication
Over-reliance on the model
Failure to heed the model
61
Sources of defective model risk
1. Errors in the methodology
2. Extrapolation beyond available data
3. Material changes in the environment, making the model obsolete
4. Inappropriate selection of underlying distribution or number of parameters
5. Fat finger errors
6. Poor data quality
7. Inconsistent models
62
Sources of defective model application risk
1. Right model, wrong application
2. Poor communication and understanding, especially about limitations of the model
3. Over-reliance on the model, especially when results look good
4. Failure to heed the model, especially when results look bad
63
How to manage model risk
1. Monitor the environment for changes that would make the model obsolete
2. Conduct thorough reviews when models are created or updated
3. Make a reasonable attempt to understand the models you use
4. Use preventative measures and best practices to mitigate the likelihood and severity of implementation and application errors
64
What could make a model obsolete?
1. Changes in underlying risks
2. Improvements in the theory or practice being modelled
3. Availability of more/better data
65
How to review a model
Ideally get an independent review and document everything.
1) Validate the input data
2) Validate the assumptions
3) Validate the results
66
How to validate model input data
- Do the data meet the requirements of the model specification?
- If the model will be used repeatedly, are the data in a consistent format every time?
- Reconcile the data to other sources and prior periods for accuracy
- Investigate outliers and any missing data. How does missing data affect the model? Errors?
67
How to validate model assumptions
Are the assumptions appropriate, documented, and used in the model as intended?
Ex: a common assumption is assuming independence of events
68
How to validate model results
- Are outputs consistent with inputs and expectations (like sensitivity tests)? Ideally, test results against other models to verify calculations.
- What are the limitations of the model? Are they documented?
- Are results in an appropriate format for the intended users and purpose?
69
What's the best practice for model risk when using a model you're not familiar with?
Make a reasonable attempt to understand the following:
- The basic workings of the model (inputs, outputs, general approach)
- The testing and validation done
- The model's complexity and the control framework
- The model's limitations
70
List some best practices to mitigate model risk
1. Acquire highly qualified staff and conduct training
2. Use rigorous approval requirements (model result stakeholders shouldn't be approvers)
3. Keep the end user in mind
4. Restrict access and use to prevent mistakes
5. Create feedback channels to correct mistakes
6. Create built-in checks
7. Record and test model and parameter uncertainty
71
Definition of moral hazard risk
In general, the risk that a party provides misleading information or does not enter into a contract in good faith.
In insurance, it's commonly referred to as the risk that the presence of insurance gives the insured an incentive to increase the level of risk taken.
72
Sources of moral hazard risk
Exists when a party can take risks without having to suffer the consequences (they may be suffered by someone else).
Ex: In 2008, banks had been giving risky loans to unqualified borrowers and expected a bail out if things went wrong
73
Definition of morbidity risk
The risk of:
- Increases in incidence rate for disability, medical, dental, and critical illness coverage
- Decreases in the rate of claim termination
74
Sources of morbidity risk
A prolonged recessionary environment, a pandemic, mortality improvements prolonging lives, improved diagnostic technology, escalation of medical costs, and misestimation of expected experience
75
Impacts of morbidity risk
If there are rate guarantees that limit or delay premium rate increases, financial losses may occur. If the firm increases premiums, there may be lapses, low sales, and a reputation impact.
76
How to manage morbidity risk
Increase premium rates, and conduct more active claims management
77
Definition of mortality risk
The risk of loss arising from unexpected mortality experience
78
Sources of mortality risk
Catastrophe, anti-selective lapse experience, a weakening in underwriting standards, new illnesses, misestimation of expected experience, medical advancements, and mortality improvement assumptions that aren't fully realized
79
Impacts of mortality risk
Steady and continued deterioration in mortality causing routine reprices can have knock-on impacts to new business and expense coverage
80
How to manage mortality risk
For adjustable products, change the premiums and/or benefits. Adjust the price of new business. Get reinsurance. Issue mortality bonds.
81
Definition of people risk
Risk that individuals working for the firm (directly or through outsourcing) fail to follow the firm's rules, processes, or procedures. An element of operational risk.
82
Sources of people risk
1. Intentional risks: theft, fraud, sabotage, dishonesty
2. Accidental risks: errors, carelessness, lack of training, inadequacy
3. Dominance risk: risk that an individual (usually the CEO) is given too much power with insufficient oversight and uses that power to the detriment of the firm
83
Definition of physical risk
An element of climate risk. Risk arising from extreme weather and environmental events.
84
Impacts of physical risk
Disruptions to critical operations, reduced value of investments (especially property and infrastructure), increase in insurance risks
85
How to manage physical risk
- Incorporate physical risk into product pricing and underwriting to reduce the impact to insurance risk. Ex: increase premiums for areas prone to heat waves
- Develop climate scenarios and conduct scenario analysis to examine how products might perform in various stressed environments.
- Develop contingency plans in case critical operations are interrupted.
86
Definition of policyholder behavior risk
Risk that the insurance company's policyholders will act in ways that are unanticipated and have an adverse effect on the company
- Ex: Persistency, contribution patterns, exercise of embedded options, management expenses
87
Sources of model risk
Inappropriate:
1) projection of past trends into the future
2) selection of an underlying distribution
3) number of parameters
88
Definition of political risk
Risk of government actions impacting the firm, especially if there was no warning or time to prepare.
- Sometimes changes can be done retroactively with no grandfathering provisions
89
Impacts of political risk
1) Changes in regulations like an increased capital requirement
2) Tax changes
3) Political instability causing market risks, exchange risks, low sales, high reinsurance prices, etc
4) Changes impacting a product line like some new public health care
5) Changes affecting investments like a reduction in the gov't's need to borrow funds
90
Definition of pricing risk
Risk that the prices charged by the company for insurance contracts will be ultimately inadequate to support the future obligations arising from those contracts.
- If prices are too high, then there's risk that the firm may not capture enough market share to recoup its initial outlay.
91
Sources of pricing risk
Incorrect assumptions in the pricing model or parameters. Adverse selection (policyholders passing more risk than expected).
92
How to manage pricing risk
Consider the following during product development and pricing:
1) Economic value creation requirements for shareholders
2) Fair treatment of customers
3) Statutory requirements
4) The speed of recouping the investment capital
5) The impact on financials
6) Tail event impact on risk tolerances
93
Definition of process risk
An element of operational risk that arises from ineffective and inefficient processes. The key is to balance efficiency and effectiveness of business processes.
94
Sources of process risk
Model risk, parameter risk, health and safety risks (like human error in following protocol or inaccessible emergency exits), and manufacturing process risk (like human error in implementation or defective construction)
95
Definition of project risk
Risk that a project is not executed as expected and causes losses
96
Components of project risk
Scope risk, defect risk, schedule risk, and resource risk
97
As a component of project risk, what is scope risk?
Risk that the project goals are changed during the implementation phase, leading to overruns in time or budget and potentially failing to meet the original project objectives. This can come from scope creep or gap risk (the original project planning was not sufficiently thorough so adjustments had to be made).
98
As a component of project risk, what is defect risk?
Risk that hardware or software acquired or developed to implement a project doesn't meet the project needs
99
As a component of project risk, what is schedule risk?
Risk of loss due to schedule failure. Project planning is important. Too aggressive, there will be bottlenecks and wasted resources from overruns. Too conservative, there will be waste if resources are allocated for longer than they are required.
100
As a component of project risk, what is resource risk?
Risk of loss due to resources not being available when required.
- Ex: losing key people before the project is completed
- Ex: running out of money to complete the work
101
Definition of regulatory risk
Risk of regulator actions impacting the firm, especially if there was no warning or time to prepare
102
Sources of regulatory risk
New regulations either directly from regulators or from the government. New employees who aren't trained in the company's compliance procedures.
103
Definition of reinsurance held risk
Risk that a reinsurer will fail to meet its obligations or that a market change causes an increase in reinsurance premiums or otherwise inadequate or unaffordable coverage.
104
Sources of reinsurance held risk
- increases in reinsurance premiums
- reduction in reinsurance capacity available for the financing of new business
- disputes with reinsurers over policy conditions (like terrorism exclusions)
105
How to manage reinsurance held risk
Renegotiate terms with the reinsurer or recapture ceded business. If a reinsurer becomes insolvent:
- the insurer will have a preferred position relative to other creditors
- the insurer will have access to amounts on deposit or assets in trust
106
Definition of reinvestment risk
Risk that it will be impossible to reinvest cashflows at their current rate of return
107
Sources of reinvestment risk
Reinvestment risk increases when interest rates decrease
108
Definition of related companies risk
Risk that the actions of a related company (like a parent, subsidiary, or other company in the same enterprise) will impact the firm
109
Sources of related companies risk
- Financial support is no longer guaranteed from a parent
- Reallocation of group expenses to the firm
- The group gets a credit rating downgrade
- Related company is in financial difficulty. Pressure to support or not able to sell/close firm in a timely manner.
110
Definition of reputation risk
The risk that a company's brand and reputation may be negatively impacted
111
Impacts of reputation risk
Low sales, high lapse
112
Definition of reserve risk
Risk that the provisions held in the insurer's financial statements for its policyholder obligations will prove to be inadequate
113
Definition of settlement risk
The risk that obligations are fulfilled, but not at the agreed-upon time. A type of credit risk.
114
Definition of sovereign risk
The risk that a country will default on its government bonds or impose foreign exchange controls that make it impossible for other counterparties to fulfill their obligations. A type of Credit Risk
115
Definition of spread risk
A type of interest rate risk. Risk that yield curve movements or changes in the shape of the yield curve negatively impact a firm.
116
Definition of stock price risk
Risk from changes in the firm's own stock price. A type of market risk. (High stock prices allow companies to pursue strategic intiatives easier)
117
Definition of strategic risk
The risk that business strategies are flawed or ineffectively executed
118
How to manage strategic risk
Ensure adequate understanding of the risks being taken on with the strategic decision, and prepare plans in case of adverse events.
119
Definition of parameter risk
Risk that parameters used in a model are not adequate (even if the rest of the model is)
120
Sources of parameter risk
Insufficient or inaccurate data used to estimate parameters. Ex: if we use whole population data to model the mortality of individual members of a pension plan, we are ignoring the fact that pension plan members tend to have better health than the general population
121
How to manage parameter risk
If you must operate with highly uncertain parameters, test a range of sets of parameters or add a margin to the parameters to bias towards conservative assumptions
122
Definition of people process risk
Risk that the human resource process fails.
Ex: If a key person resigns and there's no succession plan in place and the work has not been sufficiently documented
Ex: Staff contraints
123
Definition of credit risk
The risk that a customer, counterparty, or supplier will fail to meet its obligations (financial or service)
124
Components of credit risk
Direct default risk (settlement risk, sovereign risk, counterparty risk, and outsourcing risk) and downgrade risk
125
Impacts of credit risk
1) Exposed risk positions as a result of counterparty defaults
2) Liquidity issues caused by large sustained credit-related losses
3) Reduced availability of derivatives used for hedging strategies
126
How to manage credit risk
1) Set limits on notional amounts and current and potential exposures
2) Get collateral
3) Use covenants
127
Definition of downgrade risk
In the context of Credit Risk: Risk of changes in the perceived probability of a future default of an obligor, affecting the present value of the contract today.
Otherwise, the risk that the firm itself receives a credit rating downgrade.
128
Impacts of downgrade risk
If the firm receives a downgrade:
1) Liquidity risk because borrowing will become more expensive
2) Lapse risk, making liquidity even worse
3) Low sales
4) Damaged reputation
129
Definition of disintermediation risk
Risk that policyholders bypass intermediares (like financial institutions) to directly access a better deal elsewhere. The motivation may be to reduce cost, increase return, or increase delivery speed.
Ex: lapse annuity to attempt to achieve a higher return investing directly in the market
130
Sources of disintermediation risk
Disintermediation risk increases when interest rates increase because policyholders lapse their annuities in favor of products with higher returns
131
Impacts of disintermediation risk
Lapses and low sales cause large cash outflows and decreasing liability duration
132
Definition of financial risk
Risk that arises from financial market activities
133
Components of financial risk
Market, credit, foreign exchange, credit spread, and liquidity risk
134
Sources of financial risk
1. Asset/liability duration mismatches
2. Interest rate levels
3. Pricing spreads
135
Definition of insurance risk
Risk arising from movement in insurance variables including claim incidence, claim termination, and persistency
136
Components of insurance risk
Persistency, underwriting, mortality, morbidity, lapse, and expense risk
137
Definition of interest rate risk
Risk of loss due to adverse movements in interest rates
138
Importance of interest rate risk
Movements in interest rates create major risks for financial firms with bond-like liabilities that are matched with fixed interest investments.
- If not careful, the value of liabilities may move less or more than the value of the supporting assets as interest rates change.
- Annuities and premium payment streams for long-term insurance contracts are highly interest-sensitive
139
Components of interest rate risk
Risk arises from movements in the whole yield curve or because of changes in the shape of the curve. This is called spread risk
140
Sources of interest rate risk
When a downgrade happens (Downgrade Risk) in a credit crisis, bond yields will normally increase as the credit spread widens
141
How to manage interest rate risk
Use immunization. Duration match assets and liabilities.
142
List some impacts of rising interest rates
Saving is encouraged over spending
- Economic growth is dampened
- House prices decrease
The value of existing fixed income investments falls
- Demand for new fixed income investments at the higher rates increases
- Demand for stocks and other assets decreases
143
Definition of market risk
Risk arising from uncertainty in the market value of asset and liability cash flows
144
Importance of market risk
- Important for the financial sector because the firm's results are directly linked to the performance of their capital market investments.
- Important for other industries because market movements impact shareholder value and availability of capital.
145
Components of market risk
1. Basis risk
2. Interest rate risk
3. Foreign exchange risk
4. Equity risk
5. Reinvestment risk
146
Types of exposure to market risk
1. Absolute and relative risk
2. Directional and non-directional exposure
3. Direct and indirect exposure
147
Absolute vs relative risk
Absolute risk is measured in the relevant currency and focuses on the volatility of total returns.
Relative risk is measured to a benchmark index and focuses on tracking error (the deviation from the index).
148
Directional vs non-directional exposure
Directional exposure is exposure to movements in financial variables like stock prices or interest rates.
Non-directional exposure is exposure to hedged positions or to volatilities.
149
Direct vs indirect market risk exposure
Direct exposure includes situations where the institution faces the risk, like investing assets to make a profit for shareholders.
Indirect exposure includes situations where the majority of the risk is faced by another party (like a customer). Ex: Investing customer's assets. The impact of returns on the institution's fee income is secondary.
150
Sources of market risk
Changes in interest rates, inflation, equity returns, and foreign exchange rates.
Also poor returns in the value of a subsidiary.
151
Impacts of market risk
1. Reduced availability of derivatives used for hedging.
2. Poor returns may lead to decreased policyholder dividends that could lead to high lapses.
3. Increased disability claims from deterioration of economic conditions.
152
How can market risk affect liabilities?
Changing asset yields could affect:
1. the market value of liabilities through the discount rate
2. the amount and/or timing of future liability cashflows (like performance bonuses)
3. policyholder behavior which can change the amount and/or timing of future liability CFs
153
How can market risk affect a corporation's financial position?
1) Transaction exposure
2) Economic exposure
3) Translation exposure
154
As an element of market risk, what is transaction risk?
Risk from the direct impact of market movements on revenue and expenses
155
As an element of market risk, what is economic risk?
how market movements affect the competitive position, including buyer and supplier behavior
156
As an element of market risk, what is translation risk?
how market movements affect financial statements when converting to the home currency
157
How to manage market risk
1. Duration matching of assets and liabilities
2. Shift the investment strategy
3. Use dynamic hedging programs
4. Review premium rates and targeted business mix
158
What impacts an institution's investment approach?
The nature of the firm's market exposure. Ex: If investing in markets on behalf of another party, there might be an incentive to keep investments similar to those of competitors for fear of under-performing them. (Or keeping allocations close to those of the index they will be measured against.)
159
Definition of longevity risk
Risk that policyholders live much longer than expected, increasing liabilities above expected levels. Important for pension plans.
160
Definition of operational risk
Risk of loss from inadequate or failed internal processes, people, or systems or from external events
161
Importance of operational risk
1. Investigations of major financial disasters over the past few decades have identified operational risk issues as the main culprits in most cases.
2. Operational risks are often correlated with credit and market risks. Operational failures during stressed market conditions can be very costly.
3. If operational risk is not managed as a distinct discipline of risk, it tends to be managed differently across the company. This leads to inconsistencies and inaccurate information fed to senior leaders.
162
Some benefits of operational risk management
1) Reduce day-to-day losses and potential losses for major incidents.
2) Frees management's time to focus on revenue-generating activities instead of dealing with operational crises.
3) Strengthens the enterprise risk management system. Incorporates correlation between operational, credit, and market risks.
163
Internal operational risk components
Process risk
People risk
People process risk
Project risk
Business risk
Strategic risk
Technology risk
Model risk
Compliance risk
164
External operational risk components
Catastrophe risk, legal risk, regulatory risk, climate risk
165
How to manage operational risk
1) Monitor the external environment for KRIs like: public opinions, political uncertainties, regulatory and legal changes, and technology trends.
2) Take continuous action like brand management and conducting compliance training with employees
3) Establish reserves to cover expected operational losses
4) Adjust prices to incorporate operational risk
166
Definition of persistency risk
Risk that policyholders do not pay their renewal premiums, effectively lapsing their policy
167
Sources of persistency risk
From insurer's actions:
- premium or dividend scale changes
- changes in underwriting or qualification criteria for preferred classes
- misestimation of experience
- rating downgrade and damaged reputation
From competitors' actions:
- new products and changes in premium rates
From the economic environment:
- increasing interest rates and policyholders' need for insurance
168
Impacts of persistency risk
- Anti-selective lapse causing worse mortality and morbidity in the remaining cohort
- mismatch of asset and liability cashflows
- increased unit expenses
- worsened liquidity
- unexpected shift to less profitable or more capital-intensive mix of business
169
How to manage persistency risk
1. For adjustable products, change the premiums and/or benefits
2. Adjust the price of new business
3. Seek reinsurance solutions
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Definition of risk
A risk is a variable that can cause deviation from an expected outcome
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Alternative definitions of risk
- In a non-technical context, it means danger of loss
- In a financial context, it refers to a dispersion of possible outcomes, positive or negative
- Non-Knightian risk is a risk that is measurable and quantifiable
- Risk can also refer to the range of possible outcomes, their probabilities, the exposure to, or the possibility of gains and losses from.
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Decompositions of risk
Every risk can be decomposed into 3 parts:
1. Volatility risk or non-systemic risk
2. Uncertainty risk or systemic risk
3. Calamity risk - risk of extreme events
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What are the risk concepts
1. Exposure
2. Volatility
3. Probability
4. Severity
5. Time Horizon
6. Correlation
7. Capital
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Components of risk
Pure risk and non-pure risk. Internal and external risk.
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Pure vs non-pure risk
Pure: All downside risk like loss from extreme weather and cyberattacks. Many pure risks are insurable.
Non-pure: Not all downside. Can be pursued for a competitive advantage
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How to decide if a risk is internal or external
Consider a risk internal if it represents a failure of an internal system to protect against the external event
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Definition of technology risk
Risk of loss from the failure of a firm's IT systems or from cyberattacks
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Sources of technology risk
Criminal activity like blackmail and stealing data.
Internal risks like:
- accidental loss or corruption of data
- unidentified errors in programs
- system failure from inadequate capacity
- social media use leading to reduced productivity or accidental or intentional data leaks
External risks like:
- Outages and service interruptions (like internet)
- Loss of data through destruction of physical storage
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Impacts of technology risk
1. Increase in lapses
2. Decrease in new business
3. Upon disclosure of a data breach, reputational and legal risks
4. Increase in risk management costs and other expenses like policyholder settlements and payouts
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Preventative measures for technology risk
- Update software regularly
- Control access to systems
- Train employees regularly on the firm's cyber security practices (like phishing email awareness) so that they can recognize and react appropriately to cyber attacks
- Implement and maintain IT security throughout the firm
- Ensure compliance with related legislation
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Preparation for technology risk events
- Prepare backup systems in case of main system failure
- Purchase cyber insurance to mitigate losses
- Implement technology risk into risk and capital modelling
- Stress test current protocols to identify system and policy enhancements
- Identify and manage single points of failure (SPOFs) that could bring down critical systems
182
Pros and cons of cloud computing
- Pro: reduces the capital needed to invest in physical and electronic storage
- Con: a cyber attack on one network can make the entire cloud vulnerable to data leaks
- Con: if a vendor cloud is used, the firm is exposed to the risks that the cloud service provider (CSP) and its other users are exposed to
183
Definition of transition risk
Risk arising from the transition from a high to low carbon economy
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Sources of transition risk
Changes in government policies, regulations, consumer opinions and demand, and technological advancements
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Impacts of transition risk
1. Increased commodity prices
2. Increased emission costs and capital costs to decarbonize business
3. Changes in revenue
4. Slowed economic growth
5. Decreased inflation and interest rates
6. Increase in credit risks as certain sectors struggle in the transition
7. Increase in systemic risk from common financial sector exposures and a disorderly market adjustment (like fire sales)
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How to manage transition risk
- Reduce investments in high-carbon sectors and increase investments in low-carbon sectors.
- Update financial assumptions like expected returns, inflation and interest assumptions to ensure models reflect the evolving dynamics of the market.
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Knightian uncertainty
Refers to outcomes that are not foreseeable and/or impossible to quantify and measure
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Definition of underwriting risk
The risk that actual demographic experience turns out worse than expected. Also called demographic risk
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Components of underwriting risk
Risk associated with the insured events: biometric risks.
Risk associated with the process and conduct of the business: pricing risk, reserve risk, policyholder behavior risk
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Definition of right-way risk
A component of counterparty risk. The existence of a negative correlation between default rates (frequency) and losses given default (severity).
Ex: When exposure to a counterparty decreases at the same time as the creditworthiness of that counterparty decreases
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Definition of wrong-way risk
A component of counterparty risk. The existence of a positive correlation between default rates (frequency) and losses given default (severity).
Ex: When exposure to a counterparty increases at the same time as the creditworthiness of that counterparty decreases
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Definition of systemic risk
The risk of disruption to financial services caused by an impairment of all or parts of the financial system. It may have serious negative consequences for the real economy.
Risk that can't be reduced by diversification.
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Sources of systemic risk
In general, a trigger event causing a cascading reaction of institutional losses, destabilizing the financial system.
1. liquidity risk (like a run on the bank)
2. Emerging risks
3. Distress of a globally important financial institution
4. Interconnectedness
5. Limited substitutability
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Why is interconnectedness a source of systemic risk?
- Exposure to macroeconomic risk factors can accumulate from insurance liabilities, so diversify as much as possible
- Mutual counterparty exposure makes parties vulnerable to the distress of the others
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What is limited substitutability in the context of systemic risk?
- The difficulty for other organizations in the financial system to ensure the continuation of supply of insurance coverage after a failure or distress of an individual insurer.
- Higher risk when a small number of organizations dominate the market
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Definition of non-systemic risk
Also called diversifiable risk. Risk that can be reduced by increasing the portfolio size and diversifying
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Product risk
High risk products are ones with long contract durations and low flexibility
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How to manage concentration risk
- For financial risks, diversification can be achieved through risk limits and portfolio allocation targets
- For operational risks, diversification can be achieved through separation of operational units
ERM
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