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Types of risk
- 1. Market Risk, Liquidity Risk, Credit Risk and Operational Risk
- 2. What we will cover today Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital
- 3. Have a process to cover all risks Equity or Market Risk Overview Liquidity Risk Credit Risk Operational Risk Capital
- 6. Introduce your liabilities to your assets Overview Liquidity Risk Equity or Market Risk Credit Risk Operational Risk Capital
- 9. Participating products represent an embedded option because profits are shared 90/10 but losses are carried by the shareholder Investment return Interest rate guarantee Bonus Benefit Shareholder 10% of profits 100% of losses
- 10. Unit-linked products can have maturity guarantees Value of funds at maturity guarantee Option premium shareholder benefits
- 12. A continual management process is needed to bring the ALM framework to life Set the agenda Establish KPIs Assess Capabilities Build Align & deliver Assess Risks Articulate Strategies Evaluate Strategies Refine Strategies Develop / Refine Best Strategies Implement Strategies Monitor Performance and Environment
- 13. A dynamic process is one with a continual feedback loop Policy data Administration system Market Information Risk Tool Hedge Portfolio buy / sell order
- 17. Impact of Dynamic Hedging 20 years, volatility 25%, risk free rate 3.5% p.a., equity linked fund with expected return of underlying = 8% p.a., guarantee = initial investment = 1 1 0
- 18. Zoom 1 0
- 21. Stochastic Methods can be Run in a Spreadsheet Generate Asset Returns Read If <limit Summarize STOP Calculate and Write Results Limit depends on the shape of your distribution
- 23. Stochastic results can be powerfully presented in visual formats – no Greeks! Present Value of Distributed Earnings for a Range of Investment Strategies
- 24. What does smoothing do?
- 27. Liquidity is when market value really counts Overview Equity or Market Risk Credit Risk Operational Risk Capital Liquidity Risk
- 30. Good returns for those who have the skills Overview Equity or Market Risk Liquidity Risk Operational Risk Credit Risk Capital
- 33. To understand credit models you need to understand how debt moves between ratings
- 36. But good returns can be earned
- 38. Understanding operational risk means understanding your business Overview Equity or Market Risk Liquidity Risk Credit Risk Capital Operational Risk
- 39. … link to relevant financial measures You need to understand how your risk is built up... SG&A COGS Price Taxes Free Cash Flow Op. Cash Flow Investment Gross Margin Revenues Volume Working Capital Fixed Assets
- 40. A more detailed view of assessment and shaping Identify Risk Factors Prioritize Risk Factors Classify High- Priority Risk Factors Model and Quantify Mitigate Strategic Risk Factors Manageable Risk Factors Strategic Risk Factors Manageable Risk Factors Risk Factors That Can Be Mitigated Residual Risk Factors Finance Phase II - Shape Risk Phase I - Assess Risk
- 42. A heat map can then highlight the important risks
- 43. Capital is different to negative returns Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital
- 44. Different parties have a different approach to risk and capital Change in Value of Net Assets Policyholder/depositor security risk relates to insolvency and non-performance Enterprise owner risk relates to performance below target; ends at insolvency
- 45. What is Capital?.....it all depends Statutory capital Book capital GAAP capital Economic capital Intellectual capital Physical capital CAPITAL
- 48. RAROC identifies under-performing businesses units ... Cumulative Value Creation 0 A B C D E Excess Actual Value Creation Cumulative Capital Employed Total Capital Latent Value Creation Under-performing
- 49. What we will cover today Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital Have a process to cover all risks Introduce your liabilities to your assets Liquidity is when market value really counts Good returns for those who have the skills Understand your business Capital is different from negative returns
Editor's Notes
- The traditional EV and pricing methodology neglects the effects of interest rate guarantees and other embedded options of Insurance liabilities. In markets which give substantial interest guarantees compared with the Capital Markets interest rate and where Life insurance companies invest a substantial amount of their assets in volatile instruments like shares or real estate, the traditional way of calculating EVs and of pricing products is likely to overstate EVs and to underprice products. Regulatory constraints on the distribution of profits between shareholders and policyholders. Interest rate guarantees Right to stop premium payments. Right to waive planned premium increases. Right to increase insured sums at predetermined levels. Right to purchase annuities at predetermined levels. De facto guaranteed, option-like, profit-sharing policies.
- There are several ways to document the output of the risk identification process A simple method is to create tables where each row represents a unique risk and each Manageable risks should be prioritized and assigned to each managerial level in consideration of its priority and scope Where the line is drawn between each level depends on the number of risks, number of management levels and the capacity of management at each level to address risks Regardless of how the risks are assigned, what’s important is not to have risks “slip through the cracks” Just because a risk is not considered strategic does not mean that it should not be managed somewhere in the organization The simplest way to accomplish this is to establish a cross-functional team that reviews the information documented in the prior step and assigns a score to each risk The team should be briefed on management objectives, financial/operational performance metrics, and the risk attributes that should be considered (e.g., likelihood, severity, quality of controls)
- Once capital is attributed to each segment and the required rate of return of each segment is determined in relation to risk, a company can measure the value creation or value destruction associated with each business segment. This chart shows the result of such an analysis (or value creation audit) for a company with five major business segments arranged from left to right in declining order of value creation. In this company, A,B, create value while C is at value break even and D and E destroy value. Also note the value destruction associated with excess capital.