Chapter 4 Risk- Operational, Financial and Strategic Risk

Exposure Indicator

A metric used to identify risk inherent to an organization's operations. Example ( an insurer's risk of loss in a line of business is integral to the insurer's operations).

VaR Example

A one-day 5% VaR of $300,000 means there is a 5% probability of losing $300,000 or more over the next day.

Loss Ratio

A ratio that measures losses and loss adjustment expenses against earned premiums and that reflects the percentage of premiums being consumed by losses.

Tariff

A tax that shields domestic producers from foreign competition. When one government imposes restrictions, others typically follow, and the result is often a slowdown in global economic activity. Diversification in products and markets can help organizations succeed in a global environment characterized by trade restriction.

Basel 1 requires banks to group assets with similar risk characteristics into asset classes for the purpose of?

Calculating Tier 2 capital.

Cash Flow

Cash Flow (-) Cash Outflow

Factors that influence EaR

Changes in sales, production costs, prices of products, commodities and components used in production.

People Risk Category

Includes all employees of an organization. It can include contractors, vendors, clients, and others. Selecting the right employees provides an organization with the opportunity to grow. People can also present downside risk.

Process Risk Category

Process risk typically includes the procedures and practices organizations use to conduct their business activities. Managing these risks involves a framework of procedures and a mechanism to identify practices that deviate from those procedures.

CVaR

Provides the same benefits as VaR and also takes into accounts the extremely large losses that may occur, usually with low probabilities, in the tail of a probability distribution.

Market Risk

Market risk arises from changes in the value of financial instruments.

Operational Risk Class (People)

Risk Indicators 1. Education 2. Experience 3. Staffing levels 4. Employee surveys 5. Customer surveys 6. Compensation and experience bench-marking to industry 7. Incentives such as bonuses 8. Authority levels 9. Management experience

Operational Risk Class (Processes)

Risk Indicators 1. Quality scorecards 2. Analysis of errors 3. Areas of increased activity or volume 4. Review of outcomes 5. Internal and external review 6. Identification of areas of highest risk 7. Quality of internal audit procedures.

What is the goal of Financial Risk?

Risk optimization- A state whereby risk and return are balanced so that a maximum return is achieved for the level of risk accepted by an organization. RM should have a perspective that includes both protecting against downside risk and capturing upside risk.

Systemic Risk

Risk that is common to all securities of the same general class and that therefore cannot be eliminated by diversification.

Root Causes

The event or circumstance that directly leads to an occurrence.

Market Value Surplus (MVS)

The fair value of assets minus the fair value of liabilities.

International Trade Flows and Restrictions

The global economy is based on various free trade agreements between governments that allow products from other nations to enter their respective markets with few barriers or restrictions.

Samples of operational risk

The loss of a key supplier, the organization may be unable to meet production goals.

Fair Value

The market value, either actual or estimated, of an asset or a liability.

Put Option

An option giving the holder the right to sell a set amount of the underlying security at any time withing a specified period.

Call Option

An option to buy a set amount of the underlying security at any time within a specified period.

Market Value Margin

The amount of compensation in excess of the market value needed to induce an investor to accept the risk.

RBC (Risk Based Capital)

A method developed by the NAIC that establishes a minimum amount of capital that an insurer need to support its overall ongoing business operations based on the risk-based capital formula.

Major types of Financial Risk

* Market Risk * Credit Risk * Price Risk

Categories of Market RIsk

- Currency Price Risk - Interest Rate Risk - Commodity Price Risk - Equity Price Risk -Liquidity Risk Market risk has both downside and upside potential.

Effects of Equity Price Risk to organizations

- Risk related to an organizations own share price - Risks related to an organizations investments in external stocks and other securities. - Risks related to the average share price in a market or market sector.

Operational Risk Class (Systems)

1. Bench-marking against industry standards 2. Internal and external review 3. Analysis to determine stress points and weaknesses 4. Identification of areas of highest risk 5. Testing 6. Monitoring

Control Indicator

A metric used to identify an organizations management of risk.

Reduction of Operational Risk Through Blockchain

1. Blocks store information about transactions, say the date, time, and dollar amount of your most recent purchase from Amazon. 2. Blocks store information about who is participating in transactions. A block for your splurge purchase from Amazon would record your name along with Amazon.com, Inc. Instead of using your actual name, your purchase is recorded without any identifying information using a unique "digital signature," sort of like a username. 3.Blocks store information that distinguishes them from other blocks. Much like you and I have names to distinguish us from one another, each block stores a unique code called a "hash" that allows us to tell it apart from every other block.

4 categories of Operational Risk

1. People 2. Process 3. Systems 4. External Events

3 Pillars of Solvency II

1. Quantitative requirements of capital based on each insurer's specific circumstances. This includes a solvency capital requirement akin to economical capital that ensures 99.5% probability that the insurer will meet its obligations over the next year. 2. Requirements for insurers internal risk management process and supervision of insurers. 3. Reporting, disclosure, and transparency of the risk assessment to the public and regulators.

2 Types of Liquidity Risk

1. The possibility that large numbers of clients could withdraw funds (a run on the bank). 2. The possibility of off-balance sheet commitments, such as a line of credit being exercised.

GAAP (Generally Accepted Accounting Principles)

A common set of accounting standards and procedures used in the preparation of financial statements to ensure consistency of presentation and reported results.

Monte Carlo Simulation

A computerized statistical model that simulates the effects of various types of uncertainty.

Commodity Futures Contract

A contract either to make or to accept delivery of a specified quantity of a commodity on a given day.

Zero-Coupon Bond

A corporate bond that does not pay periodic interest income. It is a bond that is sold at a discount to par value, with the difference between the discounted sale price and the par value redemption price providing a compound fixed return amount over the life of the bond.

What is Hedging?

A financial transaction in which one asset is held to offset the risk associated with another asset.

Inflation

A general increase in prices and fall in the purchasing value of money.

Regulatory Capital

A level of owner's equity banks must hold to ensure that they have enough capital t manage operating losses and honor customers cash demands. Protects the banks and economy from the effects of downside risk.

Basel II

An international standard for banking regulations, defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events".

Commodity price risk affect what types of organizations?

Airlines, trucking companies utility companies (Fuel) Manufactures of food products use agriculture products. Changes in commodity prices can have a significant effect on an organizations CASH FLOW.

Asset Risk

All assets are exposed to asset risk, or the risk that the asset's value will decrease. The change in an asset's value reflected in policyholders' surplus; a decrease in asset value reduces the insurers policyholders surplus.

SWAP

An agreement between two organizations to exchange payments based on changes in the value of an asset, yield, or index over specific period.

Risk-Adjusted Asset

An asset that has value that declines or increases based on the extent of risk for the specific class of assets to which it belongs.

Underwriting Risk

An insurer is at risk of an underwriting loss if it collects insufficient premiums and /or significantly underestimates its loss reserves.

Liquidity Risk

An organizations liquidity is related to its cash or its ability to raise cash. It is closely related to an organizations solvency, which is its ability to meet its financial obligations.

Political Risk

Any action by a government that favors domestic over foreign organizations or poses a threat to foreign organizations.

Credit Risk-

Credit risk has only negative potential. If a borrower pays as agreed, there is no realized risk. If a borrower defaults, the downside of risk is realized.

Basel 1

Defined banks capital based on two tiers Tier 1- "Core Capital", it is essentially the same as the banks's equity capital Tier 2- "Supplementary capital", it includes all capital other that core capital, such as gains on investments, long term debt that matures in more than 5 years, and excess reserves for loan losses. Basel I prescribed a total risk-based capital ratio and Tier I (core) capital ratios as the level of capital adequacy for banks. Total risk based capital ratio = Total capital (Tier I + Tier 2) / Risk-adjusted assets ≥ 8% Tier 1 (core) capital ratio = Core capital (Tier 1) / Risk-adjusted assets ≥ 4% Basel I capital adequacy ratios included assets' credit risk in capital requirement determinations. This method had weakness, the calculations of risk-adjusted assets did not sufficiently take into account changes in the risk of assets or systemic risk.

Chapter Conclusion: Regulators require financial organizations to maintain minimum capital levels to protect depositors and the overall economy. Basel I, II, III prescribe methods to determine the capital required for financial (liquidity, credit, and market) risk and operational risk, and they authorize regulators to seize control when needed to prevent insolvency. The NAIC developed an RBC system to determine the minimum amount of capital an insurer needs to support its operations based on asset, credit, and underwriting risks. This system also authorizes regulators to intervene when necessary.

Economic capital is an estimate of the amount of capital a firm needs to stay solvent at a given risk tolerance level. Fair value assets and liability uses market prices (actual and hypothetical), which are based on future cash flows and the risk attached to those cash flows. Insurer reserves for unpaid claims and unearned premiums generally have no readily available market, so there is considerable uncertainty in estimating their fair value. An organizations economic capital is calculated using probability model of the various risk org. faces. Economic capital is increasingly being used as a standards of financial adequacy. Strategic risk are systemic risk that affect all organizations and include economic, demographic, and political risk. Organizations can not control these risk because they are external, RM pros can identify and understand these risk to help their organizations minimize negative risk while maximizing opportunity risks.

Global and National Strategic risk confronting organizations. 3 major..

Economic environment Demographics Political environment

E&O

Errors and Omisions- is a form of liability insurance which helps protect professional advice- and service-providing individuals and companies from bearing the full cost of defending against a negligence claim made by a client, and damages awarded in such a civil lawsuit.

External Events Category

External events include natural disasters (windstorm, earthquakes). Operational risk from disasters include business interruption in addition to loss of property.

Chapter Conclusion: RM pro should assist organizations in understanding and defining their operational risk. A system that effectively categorizes an organizations operatioanl risk provides framework to manage it and may include Basel II categories of people, process, systems, and external events. KRI provide leading information regarding issues that RM pros should manage before the issues lead to incidents and then losses. KRIs can be categorized by exposure and control indicators in each operational risk class. Trend analysis and benchmarks assist in determining how KRIs affect outcomes.

Financial Risk cab be categorized as market risk, credit risk, and price risk. The goal of financial risk management is risk optimization. Market and prices risk should be managed to increase upside potential while reducing downside potential. VaR and EaR are metrics used in evaluating financial risk. VaR is used primarily by financial organizations to determine the probability of investments falling below a threshold value. EaR is used by financial and non-financial organizations to model the effects of changes in various factors on an organizations earnings.

What are the two types of Credit Risk?

Firm Specific Credit Risk- Is specific to a particular financial institution and is associated with its portfolios of credit transactions. Systemic Credit Risk- When a borrower defaults on a loan originated and held by one financial institution, the risk is borne entirely by that financial institution.

Why are insurers vulnerable to interest rate risk?

First, insurers have investments, typically bonds, with duration's linked to expected claim payments from different lines of business. Second, insurers earn much of their income from investment returns on reserves before they are needed to pay claims.

Economic Environment

GDP- Economic expansion=positive GDP Recession= negative GDP growth

G-SIBs

Global Systemic Important Banks.

RM techniques for Equity Price Risk?

Hedging and derivatives and options. Call Options and Put Options allow the investor to narrow the range of price risk fro a security.

Techniques used to manage financial risk

Hedging, including the use of derivatives, is useful risk management technique. For this technique to be effective, it should be used in the context of a risk management framework and process that comprehensively addresses an organizations risk and their interrelationships.

Dodd-Frank Act

In establishing capital regulations...the appropriate Federal banking agency shall seek to make such requirements counter-cyclical so that the amount of capital required to be maintained by a company increases in times of economic expansions and decreases in times of economic contracts, consistent with the safety and soundness of the insured depository institution.

Basel II (2006)

Intended to correct eh deficiencies of Basel I. Expanded on the requirements on Basel I's rules for minimum capital requirements and established regulatory reviews and disclosure requirements.

Basel III (2013)

Introduced a global liquidity framework. Goals include improving quality, consistency and transparency of banks capital base to help the commercial banking sector better absorb shocks from financial and economic stressors. Improved RM and governance.

Systems Risk Category

Involves risks associated with technology and equipment. Technology risk include both the equipment used and the software. The risks concern the function of the technology, intentional or accidental failure, and security.

Solvency II

Is a fundamental review of the capitalization of insuerers in the EU. It establishes a set of EU wide capital requirements and risk management standards.

Credit Risk

Is a specific form of asset risk. It reflects the possibility that the insurer will not be able to collect money owned to it.

Economic Capital for Insurers

Is the capital required to maintain solvency (that is, an MVS greater than zero) at a given risk tolerance level.

Progression of Issues to losses

Issues-->Incidents-->Losses

Limitations of VaR

It does not accurately measure the extent to which a loss may exceed the VaR threshold. The limitation can be addressed with conditional value risk (CVaR).

What are the limitations of Cash Matching?

It only works when the insurer can purchase ZERO-COUPON BONDS with maturity dates and maturity values that precisely match the expected cash outflows from the underwriting portfolio. Also, if such bonds are available, the insurer would need to purchase enough of each type of security to match its expected claim payments.

Operational Risk Indicators

KRI's- Key Risk Indicators: Risk Management pro's should identify KRI's by operational class. They should identify exposure and control indicators as well. Trend analysis and benchmarks can help identify how risk indicators affect outcomes.

KRI's

Key Risk Indicators must be leading, rather then lagging, to be effective. Example (If a bank learns of rogue trading after a billion dollar loss, the bank may not survive long enough to use this lagging indicator to prevent future occurrences.)

How to calculate RBC needed to support an insurers asset risk ?

Multiplying the assets NAIC Annual Statement value by a factor provided by the NAIC.

ISO 31000

Offers risk management standards that include principles and generic guidelines to businesses internationally. It defines operational risk as "any event that affects an organization's objectives.

Currency Price Risk

Organizations that operate in more that one country have risk related to changes in the currency exchange rates of those countries.

Equity Capital

Preferred stock, surplus, common stock, undivided profits and capital reserves, and net unrealized holding gains (or losses) on securities that are not available for sale.

Strategies to Mitigate People Risk

Recruitment- Seek candidates who best match the organization's needs and culture Selection- Checking references and criminal backgrounds when legally permitted. Training and Development- Training managers to interact appropriately with other employees. Performance Management- Review periodically, and managers should provide ongoing feedback. Incentives- Incentive programs cab be developed to encourage appropriate employee risk taking and discourage inappropriate behaviors. Succession Planning- Organizations should maintain a plan for replacement of staff in crucial executive positions, such as chief exec, chief financial officer as well as in roles that perform essential functions of the organization.

Risk Based Capital RBC

Regulatory capital, calculated using prescribed factors and formulas, that is needed to support an organization's operations, given the organization's underlying risk characteristics.

SAP (Statutory Accounting Principles)

The accounting principles and practices that are prescribed or permitted by an insurers domiciliary state and that insures must follow.

Capital

The accumulated assets of a business or on owners equity in a business.

Economic Capital

The amount of capital required by an organization to ensure solvency at a given probability level, such as 99%, based on the fair value of its assets minim the fair value of its liabilities.

Strategic Risk

Such as financial crisis, or recession, can threaten an organization or provide opportunity. Strategic risk are external to an organization. They are systemic risk and therefore are outside the control of any individual organization. Also speculative risk, which have both positive and negative potential.

NAIC

The National Association of Insurance Commissioners

Financial Crises

The most serious problem for many is restricted access to credit. Most organizations fund their daily operations through short-term credit. During financial crises, credit markets may seize up, including short-term credit facilities. Organizations with large cash reserves may be able to compete effectively during finical crises because they are not as dependents on the availability of credit.

Price Risk

The potential for a change in revenue or cost because of an increase or a decrease in the price of a product or an input. Has both positive and negative potential. Price risk has two aspects for most organizations: The price charged for the organizations products or services & The price of assets purchased or sold by an organization.

Cash Matching

The process of matching an investment's maturity value with the amount of expected loss payments. This provides a means of eliminating interest rate risk because it provides a predictable stream of income until losses are due.

Action Levels

The results of the RBC formula determine the action to be taken. No action required if the RBC is 200% or more of the computed minimum. At the lowest RBC- Computed minimum level( 70-100%) the insurer is placed under regulatory control.

Commodity Price Risk

The risk associated with a change in the prices of commodities that are necessary to an organization's operations

Interest Rate Risk

The risk that a security's future value will decline because of changes in interest rates. This is a systemic risk. The US Federal Reserve's federal funds interest rate influences the interest rates on US treasury bonds, bank interest rates, and a wide range of macroeconomic factors. SWAPS can be used to hedge against interest rate volatility.

Equity Price Risk

The risk that changes in the price of a stock or another security will increase or decrease.

Reinvestment Risk

The risk that the rate at which periodic interest payments can be reinvested over the life of the investment will be unfavorable.

Demographics

The statistical characteristics of human population.

How to calculate RBC needed to support an insurers credit risk?

The value shown in the NAIC Annual Statement is multiplied by the appropriate RBC factor to determine the required RBC component credit risk.

How can organizations manage their commodity price risk?

Through the purchase of COMMODITY FUTURE CONTRACTS. Hedging through the use of derivatives linked to the price of a commodity is a technique that some organizations use successfully to manage commodity price risk.

Bank of England's Proposal

To vary capital requirements according to phases of the business cycle is similar to Section 616 of the Dodd-Frank Act in the US.

How can an organization succeed during a recession?

Trim cost and profit margins to compete successfully. Offer new or different products.

What risk Metrics can RM use to determine the probability of various financial outcomes.

VaR and EaR

VaR

Value at Risk- Measures the probability of a loss in an investment's value exceeding a threshold level. Works within a short time horizon. VaR is primarily used by financial institutions that have extensive investments in securities.

Although financial risk is external...

internal management's risk appetite and tolerance are key components of each organizations risk optimization process.