Ch39-41

4 What makes a market for risk transfer "risk efficient"?

A risk efficient market for risk A risk efficient market is one of a reasonable size, ie with many participants. Participants with excess risk are able to transfer the excess to other participants who have less risk than they are prepared to accept.

9 In the context of the canons of lending, outline the factors or questions that the investor would consider in assessing the ability of the borrower to repay the loan.

Ability of the borrower to repay • Can the borrower service and repay the debt when due? • Source of the repayments and its certainty • Safety margins built into repayment projections

8 List six additional criteria that a risk should ideally meet to be insurable.

Additional criteria for an insurable risk Moral hazard avoided Ultimate limit to liability Data with which to price risk Pooling of similar risks Independent risk events Small probability of occurrence

8 In the context of the canons of lending, outline the factors or questions that the investor would consider in assessing the amount of the loan.

Amount of the loan • Reasonableness of amount given purpose • Contributions made by the borrower to the project • Who stands to lose if project fails?

13 Outline four examples of business risks to a financial provider.

Business risks 1. Inadequate underwriting standards leading to the mis-pricing of risks (underwriting risk) 2. More claims than anticipated (insurance risk) 3. Investment in a business or project that fails to be successful (financing risk) 4. Greater exposure than planned to a particular risk event (exposure risk)

5 List the "canons of lending" (ie the principles of good lending).

Canons of lending Character and ability of the borrower Amount of the loan Security of the loan / borrower Purpose of the loan Ability to repay the loan Risk vs reward

6 In the context of the canons of lending, outline the factors or questions that the investor would consider in assessing the character and ability of the borrower.

Character and ability of the borrower • Competence, skills and experience of the key personnel • Trustworthiness, reputation, who introduced you, references • If found to have lied, do not lend

4 Outline four examples of credit risks.

Credit risks 1. The issuer of a corporate bond defaulting on the interest or capital payments 2. Any risk associated with a credit-linked event, eg the downgrading of an investment 3. Counterparty risk, where one party to a transaction fails to meet their side of the bargain, for example an individual who has sold a security fails to deliver it, although he has already received the purchase price 4. General debtors - the purchaser of goods and services fails to pay for them

2 Once a risk has been classified, list three options to a provider for dealing with the risk.

Dealing with a risk 1. Retain the risk 2. Pass it on through reinsurance or ART 3. Refuse to accept the risk

7 In both defined benefit and defined contribution schemes, how might sponsor actions contribute to the uncertainty surrounding the benefits?

Effects of sponsor actions on benefit uncertainty The sponsor may: • default on contributions at a time when funds are insufficient or when the funds held include loans to the sponsor • fail to pay contributions in a timely manner • be taken over by an organisation that is unwilling to continue to meet benefit promises • decide to reduce benefits • communicate poorly to members on issues such as benefit guarantees leading to complaints / need for compensation • generally mismanage the scheme leading to a benefit shortfall.

5 Give examples of pairs of individuals / organisations with different appetites for risk between which risk may be transferred in an insurance context.

Examples of different risk appetites in an insurance context A policyholder wants to cede risk and the insurance company wants to accept risk. An insurance company wants to cede risk and a reinsurance company wants to accept risk.

18 Outline three examples of external risks.

External risks 1. Natural disasters such as storm, fire or flood 2. Terrorist attack 3. Fiscal or regulatory changes (Note that the failure to arrange mitigation options for these risks is an operational not an external risk.)

2 Does a fall in the domestic equity market represent systematic risk or diversifiable risk?

Fall in domestic equity market - systematic or diversifiable risk? It depends on the context! To an investment fund that is constrained only to invest in the domestic equity market, this risk cannot be diversified away and is systematic. To a world-wide investment fund that can invest in many markets, the risk is diversifiable.

17 How are operational risks likely to be identified and analysed?

Identifying and analysing operational risks A model could be used but such models are only as good as the parameters input. Identification and analysis of operational risks typically requires considerable input from the owners of a business, senior management and other individuals with a good working knowledge of the business.

1 Give three reasons why risk classification is important.

Importance of risk classification Risk classification: 1. enables the price to be charged for the risk to be covered to be assessed more accurately 2. helps avoid anti-selection 3. enables the design of the contract to be shaped so that it meets the risks and needs applicable to particular classes of policyholders, eliminating unnecessary aspects and focusing on coverages that are most pertinent.

11 List six possible causes of inappropriate advice in a benefit scheme?

Inappropriate advice Complicated products Rubbish (ie incompetent!) advisor Integrity of advisor lacking, eg due to sales related payments Model or parameter errors Errors in data relating to members State-encouraged but inappropriate actions, eg encouraging people to save for retirement when this might reduce the level of State benefits they are entitled to and reduce their overall standard of living in retirement

6 What three factors make a risk insurable?

Insurable risk 1. The policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager 2. A risk must be of a financial and reasonably quantifiable nature 3. The amount payable by the insurance policy in the event of a claim must bear some relationship to the financial loss incurred

4 In a defined benefit scheme, what are the four key benefit risks?

Key benefit risks in a defined benefit scheme 1. Inadequate funds to provide the benefits eg underfunding, insolvency of the sponsor, mismatching of assets and liabilities or a combination of these 2. Illiquid assets, eg funds have been set aside but are not available when they are required 3. Benefit changes, eg to future service benefits or to State benefits 4. Not meeting members' needs eg due to inflation eroding the value of benefits or a failure to properly recognise members' needs when the benefit promise was made

5 In a defined contribution scheme, what are the three key benefit risks?

Key benefit risks in a defined contribution scheme 1. Lower than expected benefits due to lower than expected investment returns or higher than expected expenses 2. Worse than expected annuity rates - note this is a risk to the sponsor if the annuity terms have been guaranteed to the member 3. Not meeting members' needs, eg due to inflation eroding the value of benefits or a failure to properly recognise members' needs when the benefit promise was made

20 List the typical business risks faced by general insurance companies.

Key business risks for general insurance companies • claim amounts and frequencies • claim inflation • claim volatility • claim delays • latent claims • accumulations and catastrophes • court awards • expenses and expense inflation, • renewals and lapses • new business volumes and new business mix • average premium size • anti-selection and moral hazard • loose policy wording • lack of data • poor underwriting • changes in the cover provided or in the characteristics of policyholders • inappropriate reinsurance

19 List the typical business risks faced by life insurance companies.

Key business risks for life insurance companies • mortality • longevity • morbidity • withdrawals • expenses • investment returns • inflation • new business volumes • new business mix • average premium size • anti-selection and moral hazard • loose policy wording • lack of data • poor underwriting • for unit-linked contracts: mismatch between expenses and charges • for with-profit contracts: failing to meet policyholders' expectations

8 In a defined benefit scheme, what are the six key contribution risks?

Key contribution risks in a defined benefit scheme 1. Unknown future level of contributions as contributions will depend on the amount of the promised benefits, the eligibility of members to accrue and receive benefits, inflation, and investment returns net of tax and expenses 2. Unknown timing of future contributions if not funded in advance 3. The requirement to put in extra funds if there is a shortfall in the scheme - the amount and timing of which is unknown 4. Insufficient liquid assets with which to make the contributions 5. Insolvency risk due to excessive contributions 6. Take-over by a third party who is unwilling to make the contributions

9 In a defined contribution scheme, what are the four key contribution risks?

Key contribution risks in a defined contribution scheme 1. Contributions are unaffordable 2. Insufficient liquid assets with which to make the contributions 3. If contributions are linked to inflation or a salary index, that index may increase faster than expected or faster than the growth in the earnings from which the contributions will be paid 4. If contributions are fixed, benefits may be less than expected

14 Define the term liquid asset. What makes a market liquid?

Liquid asset A liquid asset is one that either: • is close to cash in nature, eg a term deposit, or • can be converted to cash quickly and the amount of cash it would become is almost certain, eg a government bond. A liquid market is likely to be a large market with lots of ready participants. (Note that a marketable asset is one that can be converted to cash quickly. But the amount of cash received is unimportant.)

3 How does a "market for risk" arise?

Market for risk The fact that different entities have different appetites for risk enables there to be a market in risk, and for risk to be transferred from entities with a small risk appetite to those with a larger risk appetite. Almost all financial transactions can be simplified down to a transfer of risk from one entity to another in exchange for a payment of money.

12 Outline three subdivisions of market risk.

Market risk subdivisions 1. The consequences of changes on asset values (due to changes in the market value of assets or changes in interest and inflation rates) 2. The consequences of a change in investment market values on liability values - this might be because liabilities are directly related to investment market values, interest rates or inflation rates 3. The consequences of not matching asset and liability cashflows - in practice a perfect match may not be possible

6 Explain how the risk of worse than expected annuity rates can be mitigated by a defined contribution pension scheme.

Mitigating annuity rate risk In the five plus years approaching retirement, the investments in the defined contribution pension scheme could be switched into the type of assets that are likely to underlie the annuity, ie bonds. This way, if bond yields fall, causing annuity rates to reduce, then this is offset by a corresponding increase in the market value of the bonds in the pension scheme fund. This process is called "lifestyling".

23 What are the risks relating to new business mix not being as expected?

New business mix risks If there are cross-subsidies in the pricing basis, there is a risk that fixed expenses will not be covered, and / or that profits will not be expected if the mix of business differs from expected. For example, larger policies may contribute more to fixed expenses and profits than smaller policies. There is a risk that fixed expenses are not met and / or profits are lower than expected if fewer large policies and more small policies are written than expected.

22 What are the risks relating to new business volumes not being as expected?

New business volumes risks Greater than expected: Writing new business requires capital. If too much new business is written, the company will incur greater than expected new business strain. Less than expected: The company may not cover its fixed overhead expenses.

21 List the typical risks faced by insurance companies under the headings: • credit • market • liquidity • operational • external.

Non-business risks for an insurance company Credit risks: reinsurer, broker and asset default Market risks: change in interest rates / inflation, market crashes, mismatch of assets and liabilities, currency risk Liquidity risks: insufficient resources to meet liabilities as they fall due Operational risks: fraud, mismanagement, systems failure External risks: natural disasters, terrorist threats, legislative and tax changes

16 Outline four examples of operational risks.

Operational risks 1. Inadequate or failed internal processes, people or systems 2. The dominance of a single individual over the running of a business (dominance risk) 3. Reliance on third parties to carry out various functions for which the organisation is responsible 4. The failure of recovery plans following an external event

10 List seven operational or external risks to a benefit scheme.

Operational risks to a benefit scheme 1. Loss of funds due to fraud or misappropriation of assets 2. Incorrect benefit payments 3. Inappropriate advice 4. Administrative costs especially compliance with changes in legislation 5. Wrong decisions by those to whom power has been delegated 6. Fines or removal of tax status resulting from non-compliance 7. Changes to tax rates or status

7 In the context of the canons of lending, outline the factors or questions that the investor would consider in assessing the purpose of the loan.

Purpose of the loan • What is purpose? Ethical and moral? Existing exposure to sector • Risks (country, currency, environmental, resource, technological) • Existence of controls to ensure money correctly applied

3 Define the following types of risks that an insurance company faces: • credit risk • market risk • business risk • liquidity risk • operational risk • external risk.

Risk definitions Credit risk is the risk of failure of third parties to repay debts. Market risk is the risk of changes in investment market values or other features correlated with investment markets such as interest rates / inflation. Business risk is risk specific to the business undertaken. Liquidity risk is where an insurer, although solvent, does not have sufficient available resources to enable it to meet its obligations as they fall due (at least, without an adverse impact on the price of assets held). The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. External risk arises from external events

3 What is the key risk to the State in relation to benefit provision?

Risk to the State in relation to benefit provision The risk is that the State is expected to put right any losses that the public incurs, especially if the State provides means-tested benefits such as a minimum income level in retirement. (For example, if the public does not make adequate retirement provision but instead spends money on their immediate lifestyle, there may be more pensioners eligible for the means-tested benefits than expected.)

10 In the context of the canons of lending, outline the factors or questions that the investor would consider in assessing risk vs reward.

Risk vs reward • Recognise that some losses may be inevitable • Thoroughness of "due diligence" process

12 List nine risks relating to the investments in a benefit scheme.

Risks relating to investments in a benefit scheme 1. Uncertainty over the level and timing of investment returns (both income and capital) 2. Inflation erosion where income / capital defined in nominal terms 3. Mismatching of assets and liabilities 4. Reinvestment risk 5. Default risk 6. Higher than expected investment expenses 7. Tax risks 8. Lack of appreciation of benefits by recipients 9. Opportunity cost of capital

1 What are the two key risks to the member of a benefit scheme?

Risks to the member of a benefit scheme 1. The benefits may be less valuable than expected 2. They may not be received at the expected (or required) time

2 What are the two key risks to the sponsor of a benefit scheme?

Risks to the sponsor of a benefit scheme 1. The cost of the scheme may be greater than expected either in real or nominal terms 2. Contributions may be required at an inopportune time

13 What is meant by "sponsor covenant"?

Sponsor covenant This refers to the ability and the willingness of the sponsor to pay sufficient contributions to meet benefits as they fall due. Sponsor covenant is a source of credit risk.

1 Define the terms: • systematic risk • diversifiable risk.

Systematic risk and diversifiable risk Systematic risk - risk that affects an entire financial market or system, and not just specific participants. It is not possible to avoid systematic risk through diversification. Diversifiable risk - risk that arises from an individual component of a financial market or system. An investor is unlikely to be rewarded for taking on diversifiable risk, since, by definition, it can be eliminated by diversification.

11 Outline four factors that the investor should consider in assessing the security of the debt and the borrower,

The security of the debt and of the borrower 1. The nature of the debt (eg debenture, unsecured) 2. The covenant of the borrower (eg credit rating, income and asset cover, level of gearing, prior ranking debt, ability to raise more debt, future prospects of the borrower) 3. Market circumstances and the relative negotiating strength of borrower and lender 4. What security is available and whether it can be realised if necessary (eg the existence of any charges against the borrower's assets - fixed or floating - and the assets to which a fixed charge is secured)

15 Why are banks exposed to significant liquidity risk?

Why banks are exposed to significant liquidity risk Banks lend depositors' funds and funds raised from the money markets to other organisations for potentially long periods. Customers may want instant access to their deposits, creating a need for liquidity. There is a risk that more customers than expected demand cash.

7 Why do insurance companies aim to pool risk?

Why pool risk? Pooling risk means that there is greater certainty in the future payments to be made on the occurrence of an insured event. This occurs due to the law of large numbers.