Types of risk


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risk is a big challange for organization

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  • 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.
  • Types of risk

    1. 1. Market Risk, Liquidity Risk, Credit Risk and Operational Risk
    2. 2. What we will cover today Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital
    3. 3. Have a process to cover all risks Equity or Market Risk Overview Liquidity Risk Credit Risk Operational Risk Capital
    4. 4. The generic risk management approach is straightforward <ul><li>Identify risk factors </li></ul><ul><li>Prioritize risk factors </li></ul><ul><li>Classify risk factors </li></ul><ul><li>Profile risk opportunities </li></ul><ul><li>Quantify impacts </li></ul><ul><li>Mitigate </li></ul><ul><li>Finance </li></ul><ul><li>Analyze opportunities </li></ul><ul><li>Develop plan </li></ul><ul><li>Implement </li></ul><ul><li>Monitor change: - Risk factors - Environment - Organization </li></ul><ul><li>Re-enter prior steps as necessary </li></ul>I. Assess Risk II. Shape Risk III. Exploit Risk IV. Keep Ahead
    5. 5. When classifying risk factors... … use a scheme that implies action <ul><li>Known environment </li></ul><ul><li>Capabilities and resources on hand to address </li></ul><ul><li>Fell between the cracks? </li></ul><ul><li>Just get on with it </li></ul><ul><li>Unfamiliar territory </li></ul><ul><li>Capabilities or resources may not be in place </li></ul><ul><li>Major change in market or business </li></ul><ul><li>Requires allocation of capital or shift in strategic direction </li></ul><ul><li>“ Manageable” Risk Factors </li></ul><ul><li>“ Strategic” Risk Factors </li></ul>
    6. 6. Introduce your liabilities to your assets Overview Liquidity Risk Equity or Market Risk Credit Risk Operational Risk Capital
    7. 7. Why do ALM? <ul><li>These two graphs come from Frank Redington’s essay “Prescience and Nescience” </li></ul><ul><li>This essay was written in 1983, 31 years after his 1952 paper on “Immunisation” </li></ul><ul><li>Assets and liabilities are durationally matched </li></ul>
    8. 8. Introduce your assets to your liabilities – and gain new insights <ul><li>“ When I first saw that graph of Ft, I had twenty years of experience of valuation problems. But that was merely knowledge: this graph was different:this was understanding. I still feel the same: that my understanding came with that graph, and has not greatly advanced in the thirty years since then.” </li></ul>
    9. 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. 10. Unit-linked products can have maturity guarantees Value of funds at maturity guarantee Option premium shareholder benefits
    11. 11. ALM Risk Management Options <ul><li>Run the Risk </li></ul><ul><ul><li>Naked </li></ul></ul><ul><ul><li>Hold capital </li></ul></ul><ul><li>Transfer the risk </li></ul><ul><ul><li>Reinsurance </li></ul></ul><ul><ul><li>Securitization </li></ul></ul><ul><li>Don’t take on the risk in the first place </li></ul><ul><ul><li>Product Design </li></ul></ul><ul><li>Hedge the risk </li></ul><ul><ul><li>Capital market solutions </li></ul></ul><ul><ul><li>Dynamic Hedging </li></ul></ul>
    12. 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. 13. A dynamic process is one with a continual feedback loop Policy data Administration system Market Information Risk Tool Hedge Portfolio buy / sell order
    14. 14. Dynamic Hedging Primer - Process <ul><li>Identify hedge instruments </li></ul><ul><ul><li>exchange traded options, futures, cash assets </li></ul></ul><ul><li>Portfolio replication for funds offered </li></ul><ul><ul><li>managed and index funds </li></ul></ul><ul><li>Partition the liabilities into hedge baskets </li></ul><ul><li>Calculate the option sensitivity of the liabilities </li></ul><ul><li>Determine hedge portfolio </li></ul>
    15. 15. The concept of Dynamic Hedging <ul><li>Price and Price change of underlying security </li></ul><ul><li>Price and Price change of option (guarantee) </li></ul><ul><li>constant in small time period  t and known </li></ul><ul><li>How can O be hedged within  t ? </li></ul><ul><li>Strategy: Buy  units of the underlying S </li></ul><ul><li>Call option:  positive -> long position </li></ul><ul><li>Put option:  negative -> short position (“short selling”) </li></ul><ul><li>Result: </li></ul>
    16. 16. Option Sensitivities - The Greeks <ul><li>Call Price = S 0 N(d 1 ) – Xe – rT N(d 2 ) </li></ul><ul><li>Put Price = Xe – rT N(-d 2 ) - S 0 N(-d 1 ) </li></ul><ul><li>d 1 = [ ln (S 0 /X) + (r +  2 /2)T ] /  T 1/2 , d 2 = d 1 -  T 1/2 </li></ul><ul><li>Delta - Partial derivative of the option value with respect to the underlying asset price ( S 0 ). </li></ul><ul><li>Gamma - Second partial derivative of the option value with respect to the price of the underlying asset. </li></ul><ul><li>Vega - Partial derivative of the option value with respect to the volatility (  ) of the underlying asset price. </li></ul><ul><li>Theta - rate of change of the option price with respect to the decrease in the time to maturity ( T ) of the option </li></ul><ul><li>Rho - Partial derivative of the option value with respect to the risk free rate ( r ) used to value the option. </li></ul>
    17. 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. 18. Zoom 1 0
    19. 19. Hedge Effectiveness <ul><li>Effectiveness = How close is (change in liabilities - change in assets) to zero </li></ul><ul><li>Ineffective Hedge </li></ul><ul><li>Effective Hedge </li></ul><ul><li>All amounts above are the MV of the assets and liabilities </li></ul>
    20. 20. What Can Go Wrong? <ul><li>Perfect Hedge Unattainable </li></ul><ul><li>Merchant bankers are not </li></ul><ul><li>charities – beware “no cost” deals </li></ul><ul><li>Transaction Costs </li></ul><ul><li>Basis Risk </li></ul><ul><li>Bulkiness of Hedge Instruments </li></ul><ul><li>Liquidity Holes/Market Gaps </li></ul><ul><li>Model Risk: Theoretical Prices Vs Market Prices, Assumptions Off => Over/Under Hedged </li></ul><ul><li>Volatility Curve Exposure </li></ul><ul><li>Cash drain from daily M2M of futures contracts </li></ul>
    21. 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
    22. 22. Practical Tips <ul><li>Keep your asset model and liability model separate – people will criticise one or both </li></ul><ul><li>Know what you are trying to achieve </li></ul><ul><li>Use different asset return models </li></ul><ul><li>Concentrate on the process </li></ul><ul><li>not the result </li></ul><ul><li>Remember – you will always </li></ul><ul><li>be precisely wrong </li></ul>
    23. 23. Stochastic results can be powerfully presented in visual formats – no Greeks! Present Value of Distributed Earnings for a Range of Investment Strategies
    24. 24. What does smoothing do?
    25. 25. Does mismatching add extra value? <ul><li>Conclusion: Mismatching and smoothing can only add limited value unless </li></ul><ul><li>you accept a very high insolvency risk </li></ul>
    26. 26. Other Learnings <ul><li>It is not one bad year but a series of poor years that are the danger </li></ul><ul><li>Match assets to your liabilities and mismatch your free reserves </li></ul><ul><li>Guarantees make the situation much worse </li></ul><ul><li>Can use any asset model </li></ul><ul><li>It is fun! </li></ul><ul><li>Can also use for reinsurance limits, test assumption ranges, stochastic profit testing and any uncertain values </li></ul>
    27. 27. Liquidity is when market value really counts Overview Equity or Market Risk Credit Risk Operational Risk Capital Liquidity Risk
    28. 28. You need to understand the liquidity requirements of your portfolio – by product <ul><li>Each major product type should have this graph </li></ul><ul><li>If nothing else, separate single and regular premium, because they have a very different liquidity graph </li></ul>
    29. 29. It doesn’t take a lot to get started <ul><li>Allocate assets to products </li></ul><ul><li>Determine period required to liquidate assets </li></ul><ul><ul><li>Cash 24 Hours </li></ul></ul><ul><ul><li>Shares – T+5, but longer if you have a lot </li></ul></ul><ul><ul><li>Property? </li></ul></ul><ul><li>Set liquidity standard eg. Must be able to meet two months lapses within 5 days </li></ul><ul><li>Factors affecting standard include </li></ul><ul><ul><li>Brand attitude </li></ul></ul><ul><ul><li>Group issues </li></ul></ul><ul><ul><li>Channel </li></ul></ul><ul><ul><li>Systems </li></ul></ul><ul><li>Monitor actual to standard </li></ul>
    30. 30. Good returns for those who have the skills Overview Equity or Market Risk Liquidity Risk Operational Risk Credit Risk Capital
    31. 31. Credit Risk <ul><li>Understand the difference between expected and actual income </li></ul><ul><li>Don’t give a guarantee without receiving a guarantee in return </li></ul><ul><li>Is it worth taking the extra risk? </li></ul><ul><li>Is making money from credit risk virtually certain? </li></ul><ul><li>Why do such big excess returns occur? </li></ul><ul><li>Acknowledgements: Paul Carrett – “Modelling Credit Risk for Australian Fixed Interest Investments” paul_a_carret@national.com.au </li></ul><ul><li>But all errors and misinterpretations are mine! </li></ul>
    32. 32. There is a credit risk premium <ul><li>Does this reflect market inefficiency, or a reward for scarce skills </li></ul>Component 1 Risk free zero coupon yield curve Component 2 Expected default cost Component 3 Risk premium
    33. 33. To understand credit models you need to understand how debt moves between ratings
    34. 34. Not all funds are lost in the event of default <ul><li>Banks can have offset provisions for other products. This helps improve their recoveries </li></ul>
    35. 35. You can then model your expected portfolio results <ul><li>One year modelling is not enough time for the full credit picture to come out </li></ul><ul><li>Complex and skewed return distributions </li></ul><ul><ul><li>transition probabilities </li></ul></ul><ul><ul><li>low frequency, high (negative) impact events </li></ul></ul><ul><li>Expected returns do not tell us enough </li></ul><ul><ul><li>are we observing the mean or the median return? </li></ul></ul><ul><li>Need to understand the entire distribution </li></ul><ul><li>Warning: Beware of Concentration risks </li></ul>
    36. 36. But good returns can be earned
    37. 37. Some words of warning <ul><li>Big problems without ratings </li></ul><ul><li>The best risks will go to the banks </li></ul><ul><li>You may not get complete information </li></ul><ul><li>Separate your credit relationship from the total relationship </li></ul>
    38. 38. Understanding operational risk means understanding your business Overview Equity or Market Risk Liquidity Risk Credit Risk Capital Operational Risk
    39. 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. 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
    41. 41. Use your experience <ul><li>Experienced staff know the major risks </li></ul><ul><li>Talk about it, set the scene </li></ul><ul><li>Look at industry experience </li></ul><ul><li>Look at your own experience </li></ul><ul><li>Identify risks first – how they can occur </li></ul><ul><li>Estimate likely loss </li></ul><ul><li>Leave risk mitigation to later </li></ul><ul><li>Allow for risk pooling – square root of the sum of the squares </li></ul><ul><li>If after the top 5, go for 20 then reduce to 10, this way the top 5 are more reliable </li></ul>
    42. 42. A heat map can then highlight the important risks
    43. 43. Capital is different to negative returns Overview Equity or Market Risk Liquidity Risk Credit Risk Operational Risk Capital
    44. 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. 45. What is Capital?.....it all depends Statutory capital Book capital GAAP capital Economic capital Intellectual capital Physical capital CAPITAL
    46. 46. What is Capital? <ul><li>Capital is assets less liabilities </li></ul><ul><li>This is available capital once required capital is subtracted </li></ul>CAPITAL
    47. 47. RAROC <ul><li>Return – Earnings before capital </li></ul><ul><li>Required Capital </li></ul><ul><ul><ul><ul><ul><li>Equity Risk </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Liquidity Risk </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Credit Risk </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Operational Risk </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Statutory Capital can be allocated to above </li></ul></ul></ul></ul></ul><ul><li>RAROC = earnings less RC x Required return </li></ul><ul><li>In a bank, negative earnings are included in earnings. In a life company deferred acquisition costs can be used </li></ul>
    48. 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. 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