Assignment 4 - Operational, Financial, and Strategic Risk

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.

Put Option

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

Call Option

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

Which one of the following organizations would most likely be able to compete effectively during financial crises?

An organization with large cash reserves.

Political Risk

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

A disadvantage of value-at-risk (VaR) is that VaR

Does not accurately measure the extent to which a loss might exceed the threshold.

Basel 1 and 2 prescribe capital requirements for:

Financial institutions

Which one of the following categories of operational risk includes many risks which are hazard risks or other forms of insurable risk?

People

An insurer's fair value is complicated because no ready market exists for trading in insurers. To calculate the fair value of an insurer's reserves, a present value discount is used and a

Market value margin is added.

______________ is integrated in every activity of an organization.

Operational risk

Control Indicator

A metric used to identify an organization's management of risk.

Exposure Indicator

A metric used to identify risk inherent to an organization's operations.

Conditional Value at Risk

A model to determine the likelihood of a loss given that the loss is greater than or equal to the VaR.

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.

Systemic Risk

The potential for a major disruption in the function of an entire market or financial system.

Leverage

The practice of using borrowed money to invest.

Cash Matching

The process of matching an investment's maturity value with the amount of expected loss payments.

The advantage of hedging is:

The reduction of financial risk.

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.

Equity Price Risk

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

Credit Risk

The risk that customers or other creditors will fail to make promised payment as they come due.

Credit Risk

The risk that customers or other creditors will fail to make promised payments as they come due.

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 populations.

What are the 5 major categories of market risk?

1. Currency price risk 2. Interest rate risk 3. Commodity price risk 4. Equity price risk 5. Liquidity risk

What are the 3 pillars of Basel 2?

1. Minimum capital requirements that address risk 2. Supervisory review 3. Market Discipline

What makes up the typical frame work for Operational Risk? (4)

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

Strategies to Mitigate People Risk (6)

1. Recruitment 2. Selection 3. Training and Development 4. Performance Management 5. Incentives 6. Succession Planning

What affects does Commodity Price Risk have on an organization? (3)

1. Risks related to an organization's own share price 2. Investments in external stocks and other securities and 3. the average share price in a market or market sector

What are the 2 distinct types of liquidity risk that are inherent to the nature of financial institutions?

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

Which one of the following is a benefit of the conditional value at risk (CVaR) method? Choose one answer. A. It takes into account the extremely large losses that may occur. Correct. The CVaR method takes into account the extremely large losses that may occur. B. It evaluates different market conditions. C. It is designed for nonfinancial organizations. D. It allows for changes in the portfolio.

A

Generally Accepted Accounting Principles (GAAP)

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 date.

Zero-coupon Bond

A corporate bond that does not pay periodic interest income.

Key Risk Indicator (KRI)

A financial or nonfinancial metric used to help define and measure potential losses.

Hedging

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

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.

Interest rate risk is:

A systematic risk

Sixth National Bank stores all of its financial records in an electronic data base. Sixth National customers are able to access their accounts on-line with a user identification number and a password. Last weekend, a computer hacker was able to breach the firewall of the electronic data base and gain access to customer account data. This operational risk for Sixth National Bank is

A systems risk

Tariff

A tax that shields domestic producers from foreign competition.

Value at Risk

A threshold value such that the probability of loss on the portfolio over the given time horizon exceeds this value, assuming normal markets and no trading in the portfolio

Value of Risk

A threshold value such that the probability of loss on the portfolio over the given time horizon exceeds this value, assuming normal markets and no trading in the portfolio.

Enterprise Risk Management

An approach to managing all of an organization's key business risks and opportunities with the intent of maximizing shareholder value. Also known as enterprise-wide risk management.

The market value surplus of an insurer is equal to the fair value of assets minus the present value of liabilities plus the market value margin. The market value margin is

An additional payment in case the reserves are inadequate.

Swap

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

Which one of the following statements is true if earnings at risk are $200,000 with 90% confidence? Choose one answer. A. Earnings at risk are projected to be $180,000. Incorrect. If the earnings at risk are $200,000 with 90% confidence, then earnings at risk are projected to be less than $200,000 10% of the time. B. Earnings at risk are projected to be less than $200,000 10% of the time. C. Earnings at risk are projected to be $200,000 90% of the time. D. Earnings at risk are projected to be greater than $200,000 10% of the time.

B

Value at risk (VaR) is a method of determining the probability of loss on an investment portfolio over a certain time horizon. The VaR method includes which one of the following assumptions? Choose one answer. A. A diversified portfolio B. A time period of no less than one year C. No trading in the portfolio Correct. The VaR method assumes there will be no trading in the portfolio. D. A time period of 30 days

C

Regression Analysis

Can be used to measure the relationship between a dependent variable (complaints) and an independent variable (adjuster experience).

Cash Flow

Cash inflow minus cash outflow.

An insurer can eliminate interest rate risk through which one of the following?

Cash matching

Determining earnings-at-risk (EaR) entails modeling the influence of factors such as

Changes in the prices of products and production costs on an organization's earnings.

The Basel 1 capital requirements differ from capital-to-assets ratio used prior to 2003 by:

Considering the relative risk of the assets.

Insurance Company monitors key indicators of underwriting effectiveness. Some indicators they monitor include: percentage of business quoted that was written, application processing time, premium volume handled by underwriters, skill level of underwriters, and benchmarking between different underwriting offices. The indicators of underwriting performance Insurance Company uses are called

Control indicators

In determining economic capital for insurers, various risks are quantified. One such risk is the potential for adverse loss experience or catastrophic losses. This risk is known as

Insurance Risk

What was considered a weakness of Basel 1?

It did not sufficiently account for systemic risk

There are numerous advantages associated with economic capital analysis. One of these advantages is that

It focuses attention on the risks attached to each of an organization's activities.

An organization's solvency is?

Its ability to meet its financial obligations

Fair value accounting uses the term market value surplus (MVS) for an organization's net worth. Which one of the following is the term used for an insurer's net worth under statutory accounting principles (SAP)?

Policyholders' surplus

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.

What best describes the management of process risk?

Process risk is best managed through a framework of procedures and a mechanism to identify nonconforming practices.

Chuck is Vice President of Claims for Insurance Company. The company has 37 adjusters in the field, and needs to hire four new adjusters. Chuck is curious about the relationship between prior experience of the adjuster and policyowner complaints. He collected data on the number of complaints for each adjuster on staff over time. Then he used a statistical technique to analyze the relationship between adjuster experience and complaints, and the trend of the relationship over time. The statistical analysis confirmed that that there were significantly fewer complaints with more experienced adjusters, and that the relationship grew stronger with more years of experience. The technique Chuck used to relate indicators to outcomes is called

Regression Analysis

When interest rates were high, Protection First Insurance Company purchased a $1,000 corporate bond that will pay $80 in interest annually until in matures in 15 years. Based on the purchase price, this bond will provide Protection First a 10 percent annual rate of return if the insurer holds the bond until it matures. Six years after the bond was purchased, interest rates had declined significantly. Although the bond still pays $80 in interest annually, Protection First can no longer earn a 10 percent rate of return on the periodic interest payments. This risk is called

Reinvestment Risk

Systematic Risk

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

Earnings at Risk

The maximum expected loss of earnings within a specific degree of confidence.

Statutory Accounting Principles (SAP)

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

Capital

The accumulated assets of a business or an owner's equity in a business.

Economic Capital is defined as:

The amount of capital required to maintain solvency at a given risk tolerance level.

Root Cause

The event or circumstance that directly leads to an occurrence.

Market Value Surplus

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

What type of risk is found at financial organizations?

They primarily have financial risk, but they also have exposures in the other risk quadrants

Basel 1 defined bank capital based on two tiers:

Tier 1 - core capital (bank's equity capital) Tier 2 - supplementary capital (everything else)

Market Risk

Uncertainty about an investment's future value because of the potential changes in the market for that type of investment.

The financial crisis of 2008 highlighted the leverage of many global financial institutions and lead regulators to focus on risk based capital. Leverage refers to:

Using borrowed money to invest.

Economic capital models the potential variability in a firm's market assets and liabilities, taking into consideration all of the firm's risks. These risks are considered together to estimate at the firm-level the probability that a firm's liabilities may exceed assets by specified levels over a one-year period. This probability measure is based on a concept called

Value at risk

Management of LMN Insurance Company is considering investing in the Stability-Growth Mutual Fund; however they are concerned about the volatility of the investment. The fund's manager said that on any given day, there is a 5% probability of losing more than 3% of the investment's worth. The statistic quoted by the fund manager is

Value-at-risk

What does Basel 2 say about operational risk?

that it is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

Risk Capital is:

the level of capital required to provide a cushion against unexpected loss of economic value at a financial institution

The required risk capital is:

usually within a confidence interval of 95 percent