Discuss the application of risk management control cycle including the relevance of external influences
and emerging risk
Describe risk optimization and responses to risk
How to optimize an objective, possibly subject to constraints
Risk optimization and responses to risk using illustrative examples
Recommend approaches which balance benefits
against inherent costs
, that can be used to manage an org’s overall risk profile
How to reduce risk by transferring it
How to reduce risk without transferring it
Understand the importance of residual risks and new risks arising following risk mitigation actions
Understand how an org’s ability to manage risk is affect by regulatory, capacity and cost constraints
After analyzing and assessing risks, the next stage of the cycle is to decide how to deal with them
Sec 1 is an overview of the aims of risk control and notes that selecting ERM responses bears similarities to the active management of a bond or equity portfolio
Sec 2 consider active portfolio management and what lessons are applicable to ERM
Sec 3 consider the possible responses to risks (reduce, removal, transfer, retain)
Sec 4 looks at alternative risk transfer which combine features of derivatives and insurance and offer innovative ways to transfer risk
Risk management can optimize the risk/return profile
of the organization by:
Support selective growth of the business
Establish process for assessing new opportunities
(incl. assessment of risk adjusted return)
Allocate capital
and other resources
to BUs or activities with high risk-adjusted return
Support profitability through risk-adjusted pricing
Prices should reflect the cost of risk (capital)
(In addition to funding costs and operational expenses)
NPV and EVA do not fully reflect the cost of risk if it is based on book values of capital
Use limit setting to control the size
and probability
of potential losses
Set basic exposure limits:
Provide absolute limits on exposure
Set stop loss limits:
Limits on actual losses, which if reached will trigger management action
Set sensitivity limits:
Keep potential losses from potential extreme events within acceptable bounds (avoid excessive concentration of risk)
Employ techniques to manage existing risks
Manage the company’s portfolio of activities where each has their own risk/return characteristics
e.g. duration matching to reduce interest rate risk
Transfer risk to a 3rd party:
e.g. with insurance or derivatives
Active portfolio management
and risk reduction
strategy are often used in preference over risk transfer as they are usually more cost effective and longer term solutions
Risk transfer
tend to be quicker and easier to implement
Recall from Module 4 Section “Internal Risk Framework Components”:
Objective of RM is to optimize the balance between risk
and return
Optimatlity is judged by reference to risk appetite
RM is not simply minimizing risk
5 fundamental concepts in the management of a portfolio of risks
Risk:
Typically expressed as the \(\sigma\) of returns
Reward:
Usually expressed as the expected return on investment
Diversification:
Reduce overall risk by investing in many different projects or assets whose returns are not perfectly correlated
Leverage:
Borrow money and investing it
\(\hookrightarrow\) increase the potential risk and return profile of the overall portfolio
Hedging:
Entering into an agreement which reduces risk, usually because the position taken is negatively correlated with the org’s existing position
ROA or ROE fail to reflect the risk taken to achieve the return
Risk-adjusted return on capital (RAROC):
\(RAROC = \dfrac{\text{risk-adjusted return}}{\text{capital}}\)
Can be calculated for an institution as a whole or for each separate activities
Can be based on actual or expected return and capital
Sharpe ratio:
\(SR = \dfrac{R_p -r_f}{\sigma_p}\)
Commonly used in the assessment of investment managers, compare those who have taken different level of risk
Measures the out-performance (in XS of risk free return) compared to the riskiness of the portfolio (\(\sigma_p\) volatility)
Return on risk-adjusted assets (RORAA):
\(RORAA = \dfrac{\text{net income}}{\text{risk-adjusted assets}}\)
Risk-adjusted return on assets (RAROA):
\(RAROA = \dfrac{\text{risk-adjusted return}}{\text{assets}}\)
Return on risk-adjusted capital (RORAC):
\(RORAC = \dfrac{\text{net income}}{\text{capital}}\) or \(\dfrac{\text{net income}}{VaR}\)
Risk adjusted return on risk-adjusted assets (RARORA):
\(RARORA = \dfrac{\text{risk-adjusted return}}{\text{risk-adjusted assets}}\)
Orgs need to adopt a risk optimization strategy which can aligned to stakeholder expectations
Remember the BoD should aim to maximize s/h value
risk
against reward
that drives optimization strategy2 types of risk
Risk particular to a company, which can be diversify away
Risk of being in the market, can not be diversified away
Total Variance of a Portfolio of Equally Weighted Assets
\(\sigma^2_p = \underbrace{\overbrace{\dfrac{\bar{\sigma}^2}{n}}^{\lim \limits_{n \rightarrow \infty} \rightarrow 0}}_{\text{Firm Risk}} + \underbrace{\dfrac{n-1}{n}\bar{\operatorname{Cov}}}_{\text{Systematic Risk}}\)
Systematic risk remains even as \(n \rightarrow \infty\)
Formula assumes each of the \(n\) securities have the same \(\sigma\) and \(\bar{\operatorname{Cov}}\) with each other
For a diversified portfolio the contribution to portfolio risk will only depends on the covariance of the security’s return with other securities
Method based on MVPT
Consider the company to be a collection of projects with their own risk/return profile
Then we can apply mean-variance portfolio theory to locate the efficient frontier for all available projects
And determine the optimal mix of projects that leads to the highest level of return given the risk appetite of the org
The MVPT can be extended to any portfolio of risks through consideration of the potential rewards arising from the adoption of any of the wide range of different risk management strategies available
Portfolio expected return: \(\mu = \sum \limits_{i} w_i \mu_i\)
\(\mu_i\): expected return on asset \(i\)
\(w_i\): proportion invested in asset \(i\)
Portfolio variance: \(\sigma^2 = \sum \limits_m \sum \limits_n w_m w_n C_{mn}\)
For 2 assets \(A\) and \(B\)
\(\mu = w_A \mu_a + w_B \mu_B\)
\(\sigma^2 = w_A^2 \sigma_A^2 + w_B^2 \sigma_B^2 + 2 w_A w_B C_{AB}\)
Minimum variance:
\(w_A = \dfrac{\sigma_B^2 - C_{AB}}{\sigma_A^2 + \sigma_B^2 - 2 C_{AB}}\)
Portfolios with the highest return for a given level of risk are said to be on the efficient frontier
\(\alpha\) will be invested in 2 risky assets \(U\) and \(V\) and \(1 - \alpha\) will be invested in a risk free asset
If \(0 < \alpha < 1\):
Positive exposure to the risk free asset which does not add to the overall risk of the portfolio
If \(\alpha >1\):
Negative exposure;
Borrow money at risk free or (\(r_F'\) with a premium to risk free) and invest in risky asset
Assuming all investors have the same view of risk and return and behave rationally
\(\therefore\) Security prices should result in equilibrium such that the expected return on any efficient portfolio is a linear function of its \(\sigma\)
The resulting set of possible efficient portfolios are shown as the boded line below:
The fact that the optimal risky portfolio can be determined without any of the investor’s risk appetite accounted for is known as the separation theorem
In order to determine where on the boded line the investor will invest, we need to know the investors risk appetite (or utility function)
4 reasons portfolio management is useful in ERM and how it aid optimization of risk/reward
Encourages companies to unbundle the business into its component projects
Enables management to decide separately how to treat each project
(e.g. retain, increase/decrease, or transfer risk)
May encourage companies to think about where they add value or can best compete
(Focus on that risk area by transferring other risks to those who can manage them more efficiently)
Provides a mechanism for aggregating risks across the org
Useful for more transparent reporting
and information purposes
Enables transfer of some or all of these risks to a central team
(Allows specialist team to hedge or otherwise manage the risk)
(Can also assess the risk-adjusted profitability if the BU was charged a price to transfer the risk to CRF)
Provides a framework in which risk concentration limit and asset allocation targets can be set
The two above operate together to achieve the org’s desired risk/return profile
Risk concentration limit
impose a minimum level of diversification for the portfolio
Asset allocation targets
ensure most emphasis or resource is allocated to the more promising opportunities/projects
Influences investment, transfer pricing and capital allocation decisions
Org can vary the price it charges a BU to transfer a particular risk to the CRF
\(\hookrightarrow\) Influencing that unit to expand or contract in that area
Having identified the risk/return characteristics of the org’s projects, management can allocate most capital to those expected to deliver the highest risk-adjusted return
Market value of an org is influenced not only by the products it is selling now, but the products that are in the pipeline (they represent options owned by the org)
MVPT highlights the importance of diversification as a means of reducing risk without necessarily reducing expected return
\(\therefore\) MVPT encourages orgs to invest in their pipeline products as well as a range of products that are currently generating revenue
Some argues that passive management (index tracking) is more sensible as there is little evidence that active management results in higher sustainable risk-adjusted returns in practice
However, when managing an organization’s portfolio of risk, there is no appropriate index to track \(\Rightarrow\) It’s not an option
It is sensible to use tools such as risk concentration limits
and asset allocation targets
and to apply the principles of MVPT
in an attempt to determine the mix of projects that sits on the efficient frontier
(take a look at Lam’s example from 105-107 to make sure the concept is understood)
Key types of responses to risk are:
Avoidance (risk removal)
Acceptance (risk retention)
Transfer (risk transfer)
Management (risk reduction w/o transfer)
4 steps process to developing risk responses:
Conduct research about possible responses and their costs
Determine a response for each risk, ensuring a deadline for implementation is specified
Assign a risk manager who is responsible for ensuring the response is implemented
Consider whether secondary risks (risks arising as a result of the response) might emerge and what the residual risks are
Key features of a good risk response
Economical:
Cost of implementation \(\ngtr\) the reduction in risk
(however low freq/high sev risk may have low expected value but the impact could be catastrophic if realized)
Well matched to the risk:
Avoid basis risk
Simple:
Avoid mistakes in executing the response
Active:
Should instigate action not just simply inform
Flexible and dynamic:
React to changing circumstances
The response chosen is necessary to :
Allows for the cost of risk when pricing
Optimize risk-adjusted performance through appropriate resource allocation
Risk transfer = reassigning risk = deflecting risk
Ways in which risks can be reduced through transfer:
Insurance / Reinsurance / Co-insurance
Provides capital if an event occurs (contingent capital) in return for a premium
Sharing the risk with a policyholder via product design
Common form of risk transfer within insurance is policy XS or co-payment, which returns some of the risk to the policyholder
Securitization:
Packaging risk into a marketable investment
Purchase of some forms of derivative
Alternative risk transfer (ART):
Combine features of derivatives and insurance
Outsourcing
Factors to consider on risk transfer
Must be based on good mutual understanding of each of the parties’ objectives
Must recognize the ability of the party assuming the risk to take action and understand the context of the risk
Cost effectiveness
Cost is typically over and above the expected loss
When risk are transferred, the upside potential may also be removed as well
Counterparty Risk (Secondary risk)
Effectiveness
There may be regulatory restrictions that reduce the effectiveness of risk transfer
(e.g. maximum permissible amount that can be transferred to a single counterparty)
(e.g. permitted reduction in regulatory capital may be capped for some forms of transfer)
The effectiveness of transfer might also be limited by the capacity of the market to which it is being transferred
(e.g. there may be no appetite in the reinsurance market to accept significant quantities of longevity risk on immediate annuities)
ERM can aid the risk transfer process:
Providing a framework in which:
An org’s net exposure to each type of risk can be assessed and diversification of risk can be recongized, so avoiding the cost of over hedging
Cost of different risk transfer strategies can be assessed
Helping to establish consistent risk transfer policies across an org.
Risk reduction without transfer = risk management = risk treatment = risk mitigation
Generally risk may be reduced by reducing the likelihood
or impact
Ways to reduce risk without transfer:
Diversify overall risk by taking on uncorrelated risks
(e.g. across types of products sold, socio economic status, geographic spread, investment asset types/sector)
Reduce random fluctuation by increasing the size of a portfolio
Some risks can be partially hedge by taking on risks with the opposite characteristics to those held
(e.g. selling both insurance produces with mortality risk and longevity risk)
Greater asset liability matching
Reduce op-risk
through implementation of strong internal controls and governance
Reduce underwriting
and pricing
risks through:
Robust underwriting practices
Intelligent data analysis using appropriate homogeneous groupings
Taking into account both past and likely future trends
Credit
and counterparty
risks can be reduced through:
Robust due diligence practices
Ensuring the agreements are tightly worded
Reduce agency risk
through:
Overall solvency
or wind-up
risk is reduced through:
There will be implementation cost and reduced potential for upside for most methods (more in module 27 and 29)
Possible to get rid of risk entirely
op-risk
, this is often easiest and cheapest to do in the planning phase of a projectOverall amount of risk taken on by a company can be reduced by avoidance, such as :
Writing fewer “high risk” products
Investing in a lower proportion in “high risk” assets
Factors to consider for risk removal
Cost of removing the risk
Impact of removing the risk on the likelihood of the project meeting its original objective
(i.e. Does it hurt your chance of meeting your original goals?)
Whether any opportunities will be lost as a result of removing the risk
Risk retention = absorbing risk = accepting risk = tolerating risk
Day to day risk are usually more profitable to retain
Organization may retain risk if:
Risk is a component of its core business
Most economical approach
(e.g. expensive to document and settle relatively small losses)
No alternative
(e.g. no one to transfer the risk to at an acceptable cost)
3 circumstances that give rise to residual risk
Conscious decision was made to retain them
Result of a risk response action
(i.e. secondary risk like counterparty risk)
Result from an imperfect hedge
(i.e. basis risk)
Important to identify residual risk in the risk planning stage
For remaining residual risk that cannot be insured against or hedge, risk capital should be held in order to mitigate their impact
ART:
Non-traditional risk transfer product which often combine features of both insurance and derivatives
2 broad categories:
Vehicles based on capital market instruments1
Other unconventional vehicles2 used to cover conventional risks
(e.g. non capital market risk transfer)
In order to develop and offer ART products to be used by 3rd parties an organization needs to be able to:
Quantify risk in terms of both likelihood
of occurrence and size
Package, underwrite and sell securities
Also need to hold capital if the org retain any of the risk itself
Improved organizational focus
Customiztion and timing
Typically customized to the org, enabling it to obtain the level and nature of cover it wants
Some can provide capital faster (e.g. cat-e-puts) than more traditional approaches (e.g. right issues) and at the precise time that it is most needed
Cost reduction and simplified admin
Multi-line policy generally cost less (than à la carte)
As any natural hedges or lack of correlations can be recognized in pricing
Multi-line policies reduce number of separate policies
\(\hookrightarrow\) reducing admin cost
Tax efficient methods can be employed
(e.g. offshore captives)
Pooling of risks can lead to cost savings due to diversification
(e.g. risk retention groups)
Earnings stability
Can cover multiple types of risk for extended period of time
\(\therefore\) enable an org to smooth earnings more easily than through a series of 1-yr contracts
Marking-to-market
ART is relatively new (started in 1970s) and a rapidly developing area
Problems include:
Higher initial costs than conventional products
Products are more complex than conventional products
\(\hookrightarrow\) Increasing the time and cost of developing a solution for an org
An org may need to change the way it assesses and manages risk in order to gain maximum benefit from ART
Staff need to be educated about ART so they can
Potential drivers for increased use of ART in the future
Conventional insurance becomes more expensive (cost savings offered by multi-line policies)
ERM becomes more widespread
Orgs that integrate their risk assessment and management across the org are likely to appreciate integrated risk transfer mechanisms
It becomes widely recognized that companies should focus more on their core business and eliminate or transfer other risks
Vechicles based on instruments from the capital markets
Insurance linkes bonds:
Bonds whose interest and/or principle are wholly or partially forfeit if a specified event occurs
Most popular way of transferring nat cat risk from reinsurers to the capital marekts
Securitization:
Process of packaging risks into debt or equity instruments that can be traded in financial markets
Cat-E-Puts:
Catastrophe Equity Put Options allowing a company to issue and sell equity at a predetermined price in the event of a specified cat event
Contingent Surplus Notes:
Notes providing access to capital to their holders in the event of a loss event
Credit Default Swap:
Derivatives under which the buyer pays premiums to the seller, whoe makes a payment to the buyer in the event of a credit default
Weather Derivatives:
Policies triggered by specified meteorological events of predetermined magnitude
Unconventional vehicles used to cover conventional risks
Self-Insured Retentions (SIR):
Retentions of capital set aside for use under negative contingencies
Risk Retention Group (RRG):
Self-insurance capital pooled by a number of small-to-medium sized companies
Captives:
Subsidiary companies set up solely to insure the parent company
These are often located offshore to exploit tax advantages
Rent-a-Captives:
Captives shared among several medium-sized companies
Funds are managed centrally
Earnings Protection:
Policies triggered by a specified earnings shortfall within a given financial period
Finite Insurance:
Insurance policies extended over a multi-year time period in order to smooth profit and loss
This kind of insurance often involves very little risk transfer, but has the effect of reducing capital requirements and/or taxes
Integrated risk and multi-trigger policies:
Policies covering a basket of different risks, some of which are not conventional insurance risks
Sometimes called insuratization
Multi-Trigger Policies:
Policies triggered only if a number of different specified events occur within a given timeframe
Multi-Year, Multi-Line Policies:
Policies covering a basket of different risks, spread out over a specified number of years
Understanding the product
Questions purchaser should ask:
How does the product work?
How are the triggers determined?
What would the payoff be, in a range of scenarios?
Have similar products been purchased in the past?
How were they price?
Are the purchasers satisfied?
What is the impact of the prodcut on the organization’s economic capital requirements?
Could the same cover be provided through conventional prodcuts?
If so, how does the cost compare?
Does one approach offer tax or regulatory advantages?
Assessing the seller
Question purchaser should ask:
Has the seller much experience of ART deals?
If so, were the deals similar to the deal proposed now?
How have the previous deals performed?
Are any previous puchasers willing to provide reference
If the organization has not done ART deals in the past, does it have the requisite skills?
How does the seller measure and assess risk?
What models and methods does it use?
Does it outsource the risk management? If so, how reliable the organization offering the measurement service?
Does the seller have sufficient capital and/or reinsurance to meet potential claims?