Past Exam Questions: April 2017

Question 1

Explain the importance of risk definitions in the context of a risk appetite statement

Answer 1

Important to have internally consistent definitions of risks
… such that all risks are covered
… and there is no duplication.

It is important that the risk definitions are expressed in a way which is CLEAR and UNAMBIGUOUS.

Most importantly - all employees need to have the same understanding that a particular risk has a particular meaning.

It is important to avoid breaching stated tolerances or limits due to a misunderstanding.

Question 2

Define the 95% one-day Value at Risk

Answer 2

The maximum loss expected …
… over a one-day period
… with a 95% probability or level of confidence.

Question 3

Assess the relevance of downside risk measurement to determining risk in a bond portfolio.

Answer 3

Downside risk is the concept of risk being about loss rather than uncertainty.

In other words, it suggests an asymmetric measure of loss.

This is particularly relevant to bonds because the upside potential is limited (as the best you can do is get your money back)…
… particularly over long time horizons
… whilst the downside potential is more significant (you could lose everything)
… and the expected position is closer to the maximum upside than the maximum downside.

Risk of significant loss is less for a portfolio of credits than for a single bond, due to diversification.

This means that it is important to have a risk measure that captures this asymmetry of returns, ie a downside risk measured.

Question 4

Why might a company structure management compensation as shares vesting in a number of years, rather than a cash payment?

Answer 4

• To incentivise management to continue to work towards the profitability of the company.
• To reduce the potential for agency risk.
• To increase the probability of managers staying with the company.
  … hence retaining knowledge and expertise in the company.
• By delaying the payment, the company hopes to ensure that the management will work towards profitability at least until the shares vest.
• Using shares means that there is less need for the company to come up with large amounts of cash.

Question 5

What are the potential downsides of offering management shares in the company vesting over a set period?

Answer 5

• Working towards short-term profitability does not necessarily equate to driving towards the best long-term interest of the firm.
• In theory, management could use options to hedge out the share price risk.
• If the company is big, management may not feel that they could impact profitability.

Question 6

Describe the components of a credit spread

Answer 6

• Reward for expected defaults
  the amount of the spread required to compensate for the expected level of future defaults.
• Risk premium / credit beta
  reward for the uncertainty over future level of expected defaults.
• Liquidity premium
  reward for the fact that it might not be as easy to sell (at an acceptable price) a corporate bond when funds are required.
• Trading cost
  compensation for the additional cost of trading corporate bonds relative to gilts.
• Skew
  reward relating to skewness of corporate bond returns if investors dislike losses more than they like gains.
• Tax
  reward for the fact that corporate bonds may be less tax efficient than gilts.
• Spread volatility
  reward for uncertainty over the spread.

Reward for the fact that gilts can be used as collateral with derivative contracts.

Question 7

Explain the rationale for using CDOs to repackage corporate bond risk

Answer 7

• May be used to reduce credit risk
• More likely used to take advantage of potential mis-pricing of corporate bonds…
  … particularly at lower grades.
• Allows investors with a range of different risk preferences to take advantage of this mis-pricing.
• Relies in particular on the liquidity premium…
  … and the fact that it is typically higher for certain credit grades.
• Also relies on the CDO being sufficiently diversified to profit from defaults that are in-line with expectations…
  … rather than being damanged by macro events that affect all credits to the same extent.

Question 8

Outline the factors other than credit risk that should be taken into account when setting the attachment points for the CDO.

Answer 8

• The correlation between securities
  … including the shape of the correlation
  … particularly in the tails
  … and hence the broader choice of correlation approach.
• This is linked to the choice of securities included
  … and the number of securities used
  … and who gets to choose the securities (not always the asset manager, sometimes the end investor)
• Also need to consider implications for the price
• Investor preferences / expectations
• Level of investor demand
• Attachment points offered by other CDOs.

Question 9

How might a bank use the issuance of CDOs to manage its economic capital position?

Answer 9

• Banks must hold capital in respect of the risks they face. Among these risks, one of the most important is credit risk:
  … coming mainly from loans made by the bank
  … to individuals (eg mortgages) and businesses.
• The amount of capital required is determined by the number and quality of loans written
  … and the payoff profile of the bank’s interests in the loans.
• Although the bank can reduce its capital requirements by reducing the number of new loans it makes (or increasing their quality), or by selling on the existing loans, it may wish not to follow these routes for profit reasons.
• It might therefore try to package them in such a way that it is able to retain a portion of the risk (or return)…
  … in such a way that the total return as a proportion of the capital used is as high as possible.
• The bank may simply convert some of its loans into securities (collateralised loan obligations, a form of CDO)
• and hence remove them from its balance sheet completely
• passing risk to other parties through the CDO will reduce the bank’s capital requirements.

Question 10

10 Ways in which a bank might change the level of economic capital that it has available

Answer 10

• transferring risk
• issue/redeem equity capital
• change the volume of business written
• change the mix of business written
• change the pricing of business
• merge with / acquire another company
• change asset types held or degree of asset/liability matching
• change underwriting / due dilligence practices
• change the general level of risk management controls / governance.

Question 11

Possible effects on a country if it experiences major failure of a staple crop (e.g. drought / plague)

Answer 11

• Population loses a food source
  … and needs to rely on alternative domestic foods and imported foods.
  … Increased demand pushes up prices.
• The reduced supply of the crop will reduce supply, increasing prices of the crop.
• There may be pressure on government funding
  … if the government is unable to support the population, this may lead to famine.
• Crime rates may increase due to poverty
• Healthcare standards may decrease
• Large numbers of farmers become bankrupt
• Unemployment will rise as people are made redundant
• Businesses / farmers may try to borrow money to cover the increased costs / loss of revenues.
• Interest rates may increase sharply.
• The government has less tax revenue.
• Inflation may rise sharply as food prices increase.
• The government will loss export revenue.
• The government will need to take action to prevent economic downturn.
• There may be social and civil unrest when people are unemployed, hungry, running out of money.
• The government may be removed / political turmoil.
• Increased emigration.
• The government may need to ask for international aid.
• The impacts may negatively impact tourism and the income gained from it.

Question 12

Risks to which a small insurance company is exposed that can typically be quantified

Answer 12

• Financial market risk
  The risk arising from changes in investment market values in relation to assets in which the insurer invests (eg equities, bonds and derivatives
• Interest rate risk
  The risk arising from changes in interest rates. The insurer may have loans, issued debt or invested in bonds.
• Credit risk
  Risk that a counterparty may default on an agreement or the risk of variations in credit spreads. The insurer may have issued debt or invested in bonds and be exposed to changes in credit spreads.
• Foreign exchange risk
  Risk arising from the movement in foreign exchange rates. The insurer may have foreign investements or overseas clients.
• Insurance risk
  Risk that the timing, frequency and/or severity of an insured event varies from the expectations of the insurer at the time of underwriting / pricing.
• Market demand risk
  The risk of lower sales or profit margins arising from changes in market conditions, where “market” refers to the market into which the company’s products are sold. I.e. risk of significant fall in the sale of insurance policies.

Question 13

Risks to which a small insurance company is exposed that are typically difficult to quantify

Answer 13

• Operational risk
  Risk of losses resulting from indequate or failed internal processes, people and systems - due to the fact that an insurer writes complex insurance policies, handles client money and carries out investments.
• Operational risk in relation to external events
  (or catastrophe risk), such as business continuity risk or disaster risk: the risk that an external event such as a natrual disaster affects the physical ability of the insurer to carry on business at its normal offices.
• Liquidity risk
  Risk relating to managing short term cash flow requirements and funding. The insurer may not have enough liquid assets to pay premiums as they fall due.
• Reputational risk
  Risk that event or circumstances have an adverse impact on the insurer’s reputation or brand value.
• Counterparty risk
  The risk that another party to a transaction or agreement fails to perform them in a timely manner, eg the insurer may have sales agents that fail to pass on premiums in a timely manner, or suppliers that fail to deliver goods.
• Other risks
• – regulatory risk
• – strategic risk
• – political risk
• – project risk
• – agency risk
• – legal risk

Question 14

Key features of the Sarbanes-Oxley Act of 2002

Answer 14

• Strengthens the power of the audit function
• The length of appointment of an audit partner within a firm is limited to five years.
• It restricts the provision of audit and non-audit services by the same firm to the same client.
• It requires non-executive directors on audit committees.
• A Public Company Accounting Oversight Board was also established to oversee the audit of public companies.

Question 15

Outline an appropriate enterprise risk management framework for a small insurer:

COMPANY STRUCTURE

Answer 15

• The Board has a responsibility to ensure financial reports and disclosures are accurate and so needs to set a culture that emphasises that importance.

establish an AUDIT COMMITTEE

• to oversee the financial reporting of the company
• it should consist of non-executive directors, including independent NEDs
• the internal audit function would need to be independent of any financial reporting within the company, and report to the audit committee
• an independent external auditor would also be employed to regularly audit the insurer

RISK FUNCTION

• The manager of the Risk Function could be designated the Chief Risk Officer
• establish a RISK COMMITTEE:
  
  • • chaired by the CRO
  • • responsible for implementing and maintaining the ERM framework
  • • ensuring that regulatory and accounting requirements are met
• The risk function needs to work effectively with line management through a partnership model.

Question 16

Outline an appropriate enterprise risk management framework for a small insurer:

POLICIES AND PROCESSES

Answer 16

• A risk management policy should be set and implemented
• An accounting and financial reporting policy should be implemented and tested by the internal audit function.
• The insurer should ensure it has a strong Risk management culture, where openness is encouraged and valued.
• Do, check, review process for all financial processes to encourage SEGREGATION OF DUTIES
• Approval of large transactions should be subject to additional controls.
• Teams should be incentivised to raise and manage risks or potential accounting concerns.
• Risk-adjusted performance measures should be used.
• Adhering to regulatory or accounting standards could be a performance objective for all staff, with bonuses linked to performance or prizes for raising and managing regulatory / accounting risks.
• Regular training should be mandatory for all staff
• More regular internal management accounts could be produced to highlight issues more quickly.
• The RISK MANAGEMENT CONTROL CYCLE should be utilised:
• – identification whenever a new regulation is published
• – assessment - confirmation from the regulator and an impact assessment
• – management/mitigation including updated processes and training
• – monitoring including review to ensure the new regulation has been implemented appropriately
• – modification of the risk taxonomy and any further processes if required.
• Good risk management includes open and regular communication with stakeholders including the regulator / accountancy body.

Question 17

Assess the suitability of the lognormal distribution for modelling the risk of fraudulent activity

Answer 17

• With good controls the frequency of fraudulent activity should be low, but the severity of the loss when fraud does occur can be high.
  The lognormal distribution is fat tailed and skewed so it shares these features.
• There is no upside to fraud risk, and the lognormal distribution is one-sided.
• So the lognormal distribution may be suitable.
• However, given the scarcity of data extreme value distributions may be more appropriate (or another approach, eg scenario testing).

Question 18

Justify the statement:

Dependencies between a given risk driver pairing may not be constant and this is an important feature to be modelled

Answer 18

• There may be changes over time as the risks evolve in line with changes in the environment.
• There may be changes over time as the risks evolve in line with changes in the business mix.
• It is also likely that dependencies will vary in the tails (ie extreme events)
• In particular, dependencies or correlations are often heavier in the tails.
• Understating the (tail) dependencies or correlations in the modelling performed could understate the risk exposure.
• This is particularly important in relation to tail dependencies, since regulatory / economic capital tends to be set in the tails.
• And in relation to operational risks, which often tend to be “extreme” events.

Question 19

9 Different copulas for aggregating risk drivers and their key properties

Answer 19

INDEPENDENCE COPULA
assumes the marginal distributions are independent

COUNTER-MONOTONICITY (MAXIMUM) COPULA
Assumes the marginal distributions of one factor is one less the marginal distributions of the other (ie full negative dependence).
- only exists in the bivariate case

CO-MONOTONICITY COPULA
Assumes the marginal distributions are monotonic transforms of each other (ie full positive dependence)

GUMBEL COPULA
Assumes upper tail dependence, but no lower tail dependence.
As risk factors increase the dependency increases and extreme positive values occur together.

FRANK COPULA
Assumes neither upper nor lower tail dependence.
Has a simple closed form solution making it easier to compute.

CLAYTON COPULA
Can assume only lower tail dependence, or no tail dependence.
As the risk factors decrease the dependency increases and extreme negative values occur together.

GENERALISED CLAYTON COPULA
Assumes both upper and lower tail dependence.
Fat tails exist for both extreme high and extreme low risk factors.

GAUSSIAN COPULA
Has no tail dependence.
Instead of a single correlation coefficient, it has a matrix of coefficients to help describe the relationships between pairs.
It requires more data to parameterise it.

STUDENTS' T COPULA
Has tail dependence.
But allows the strength of the dependence in the tails to be varied.
Also has more parameters.
Needs more data to parameterise it.

Question 20

2 Alternative techniques for assessing aggregate operational risk

Answer 20

SCENARIO ANALYSIS

• based on historical data
• or hypothetical scenarios defined internally with expert input
• to define correlations
• or to directly assess the aggregate risk.

IMPLIED CAPITAL APPROACH

• the overall risk capital at a given level is assessed for all risk.
• the capital for other risks is subtracted (credit, market, insurance etc).
• the remaining risk capital is assumed to be operational risk
• ignoring interactions like diversification benefit