Good risk management enables a provider to (12)
- Improve the
- – STABILITY
- – QUALITY of their business
- Improve their growth / returns by
- – EXPLOITING RISK OPPORTUNITIES
- – BETTER MANAGEMENT AND ALLOCATION OF CAPITAL
- Identify opportunities arising from NATURAL SYNERGIES
- Price products to reflect their INHERENT LEVEL OF RISK
- Give stakeholders in their business confidence that the business is WELL-MANAGED
- To satisfy the regulator / STATUTORY REQUIREMENTS
- Improve JOB SECURITY for employees
- DETECT RISKS EARLIER thereby avoiding surprises
- meaning that they are CHEAPER AND EASIER to deal with
- Determine COST-EFFECTIVE means of risk transfer
6 risks faced by a pensions product
- market risk:
- – assets do not perform in line with expectation and there is not enough to cover the liability
- – a risk mismatch between the assets and liabilities, perhaps by term / nature
- longevity risk:
- – the pensioners survive longer than expected
- inflation risk:
- – the benefits becoming worth less to members
- liquidity risks:
- – funds not available as they become due, or at an unsatisfactory cost
- more people retiring eligible for the benefit than expected
- Counterparty risk (default of an insurer / debtor)
Systematic risk
Risk that affects an entire financial market or system.
It is not possible to avoid systematic risk through diversification.
Diversifiable risk
Arises from an individual component of a financial market or system.
It is possible not to take on diversifiable risk as (by definition) you should be able to diversify it away.
3 Types of credit risk
- Counterparty risk
- Asset default
- Debtors failing to pay
4 Advantages of using reinsurance
- provide technical expertise
- data, knowledge and experience
- could reduce volatility in claims figures
- could lower capital requirements
4 Disadvantages of using reinsurance
- pass on profit to the reinsurer
- decreases the flexiblity as they might impose requirements on pricing, underwriting and claims assessment
- increased administration
- introduce counterparty risk
Outline the risks that a fireworks manufacturer is exposed to
• Product failure - firework not working in the anticipated way causing injury to consumers or not working at all (recall, refund, reputation damage)
• Fire risk for the factory (property damage) - explosions happening leading to large fire affecting the factory and surrounding area
— this could significantly damage its ability to meet orders (business interruption)
• Injury to staff - burns or chemical injuries in the production of fireworks
• Costs too prohibitive - making the fireworks may be too costly to sell to consumers
— this could be due to costs of powder required to make the fireworks and other expense related risks
- Political risk - government may ban the sale of fireworks
- Fireworks fall out of fashion
- Economic risk since fireworks could be considered a luxury
- Liquidity risk as sales may be concentrated at certain times of the year
- Increase competition, either locally or internationally leads to reduced business
- Increase in tax on fireworks
ALSO:
- credit risk
- fraud risk
- business risk
- operational risk
Describe the circumstances that might lead to a risk:
- not needing financial coverage
The risk would need to be trivial.
Alternatively insurance / guarantees may already exist from the government / external bodies.
The risk may be non-financial and there may be processes in place to deal with this.
Describe the circumstances that might lead to a risk:
- being retained
In this case the risk would be material if it arose.
However, the company may think that the risks are unlikely to bite.
Or they have sufficient funds to cover any potential costs themselves.
Suitable alternatives may not be available or may be too expensive.
The company may be happy to take extra measures to deal with the risk.
The company may want to retain any upside of the risk.
Describe the circumstances that might lead to a risk:
- being fully transferred
If the company is risk-averse.
They believe that insurance is necessary since even if the risk is unlikely, its impact will be too great for them to cover.
Alternatively they may believe that they will be taking on significant risk but the premium represents value (and/or they can afford it)
This may be a legal requirement.
Describe the circumstances that might lead to a risk:
- being partially transferred
They may not be able to afford a full-cover premium.
This could be a trade-off between the likelihood and costs of minor incidents versus the saving in premium.
Insurance companies may be unwilling or unable to accept the full risk.
6 Assumptions that may be needed for funding a pensions scheme
- Mortality before retirement
- Mortality after retirement
- Future changes in mortality
- Future salary levels
- Future investment returns
- Future inflation rates
Reasons why different schemes might use different assumptions in setting their funding level
Different:
• membership profiles and maturity
• demographic characteristics of the scheme memberships
• investment strategies
• scheme size
• funding aproach
• measures of inflation in the scheme rules
• assumptions
• benefits (some provide additional benefits)
• views of trustees
• models to assess risks
• levels of knowledge about their membership
How could the cost of a state policyholder protection scheme be met?
The cost of the scheme may be spread across:
• Policyholders (higher premiums / charges)
• Capital providers (ranking of capital provided on insolvency)
• Companies (levies on insurance companies)
• State (funded through taxation)
Advantages of using a standard model prescribed by the regulator
- The standard model would not require detailed work to be done on building the specific model
- There will be considerable time and effort involved on the part of the insurance company in reviewing and seeking approval for an internal model.
- There will also be significant costs involved
- The company may not have enough data / experience to build its own model
- The prescribed model may fit well with its products and risks, and thus be appropriate.
- The model needs to be resilient over time, which will be easier with a standard model than with an internal model (since the regulator will assist)
- a standard model may help address any concerns that the public may have with the company. This could lead to increased confidence.
- May allow the insurance company to obtain regulatory approval quicker from the regulator as they will not need to review and approve the internal model along with understanding any specific risks.
Risk management tools an insurer could use
• Diversification:
- – by lines of business
- – geographical region
- – providers of reinsurance
- – investment asset classes
- – investment assets held within each class of business
• Claims control procedures
— only pay out claims intended and defined in the policy. Paying more claims will reduce profit, but consider the cost of claims control.
- Underwriting at the proposal stage
- Management control systems (good management controls can reduce the provider’s exposure to risk)
- – Monitoring of liabilities to detect accumulation of risk
- – Accounting and audit (ensure accurate provisions and capital requirements, and that premiums are collected. It reassures providers of finance)
- – Options and guarantees
- Reinsurance can be used to reduce capital or the level of claims
- Alternative risk transfer
- produces tailor made solutions for risks that the conventional market would regard as uninsurable.
- — These might include: Integrated Risk Cover, Securitisation, Post Loss funding, Insurance derivatives, Swaps
Underwriting
The assessment of potential risks so that each can be charged an appropriate premium.
Goals of underwriting
- Protection from anti-selection, including misrepresentation at the proposal stage
- Identify risks for which special terms need to be quoted.
- For substandard risks, the underwriting process wil identify the most suitable approach and level of special terms to be offered.
- Risk classification to ensure that all risks are rated fairly.
- Ensure that claim experience does not depart too far from that assumed in the pricing basis.
- Financial underwriting to reduce risk for larger proposals.
- Consider the cost / benefit of underwriting.
Discuss the purpose of claims control systems
to ensure that only the “right” claims are paid.
to protect against fraudulent or excessive claims. Only pay claims within the policy conditions.
Discuss the purpose of management control systems
Management control systems are focused on the operational management of the risk exposures.
Good quality data focused on the risk factor exposures is essential to adequately manage and provision for the risk.
A company will have a risk appetite to cost effective controls around the data.
However, a control failure is an operational risk event.
Good accounting and audit procedures do not change the risks, however, failure to apply good accounting or audit procedures can cause unintended risks, eg too high provisions can understate financial strength and cause a “run-on-the-bank” scenario. Lower credit ratings can close of risk management tools where counterparties will not do business or only at a higher price.
Failure of the accounting or audit procedures is an operational risk event and could cause regulatory issues.
Monitoring liabilities taken on is an essential operational risk management tool. It can detect operational risk events mis-pricing of risks or failures in claims control systems. It is also a risk management tool to balance the risks accepted to stay within risk appetite.
Consider cost / benefit of setting up and implementing the controls.
Liquidity risk (in the context of a company)
Liquidity risk is the risk that a financial institution does not have sufficient financial resources available to enable to meet it financial obligations as they fall due.
Liquidity risk (in the context of financial markets)
Where a market does not have the capacity to handle (at least, without a potential adverse impact on the price) the volume of an asset to be bought or sold at the time when the deal is required.
Market risk
The risks related to changes in investment market values or other features correlated with investment markets, such as interest or inflation rates.
The risks can be divided into
- the consequences of changes on asset values
- the consequences of investment market value changes on liabilities
- the consequences of a provider not matching asset and liability cashflows
