Sources of Risk

Sources of Risk11IntroductionThis presentation will look at the main categories of risk faced byfinancial product providers and the different ways to mitigate some of these risks.2Outline(3.1.1) Describe the risk management process for a business that can aid in the designof products, schemes, contracts and other arrangements to provide benefits oncontingent events.(Covered in part in this chapter.)(3.1.3) Discuss the difference between systematic and diversifiable risk.(3.1.5) Describe credit risk and the use of credit ratings.(3.1.6) Describe liquidity risk.(3.1.7) Describe market risk.(3.1.8) Describe operational risk.(3.1.9) Describe business risk.3What is Risk ???41.1 Categorising risk51.2 Systematic and diversifiable riskSystematic riskSystematic risk is risk that affects an entire financial market or system, and notjust specific participants. What are examples of Systematic Risk?Diversifiable riskDiversifiable risk arises from an individual component of a financial market orsystem.

61.2 Systematic and diversifiable riskCan a risks be both systematic and diversifiable?Whether a risk is systematic or diversifiable depends on the context.For example:Market Risk:To a domestic equity fund SystematicTo a world equity fund Diversifiable.72 Credit risk and the use of credit ratingsIn general:The risk of failure of third parties to repay debts.Examples:The issuer of a corporate bond defaulting on the interest or capital payments.Counterparty risk e.g. Reinsurer.General debtors e.g. Policy Holders ,Brokers.82.2 Principles of good lendingAlso known as the canons of lending.Include:Character and abilityPurposeAmountRepayment92.2 Principles of good lendingCharacter and Ability.Is the borrower (and/or its principals) known, competent and trustworthy? Who introduced them? Can references be obtained?When lending to a firm/company the following should be considered:Loan Book HistoryIssuer.Market Perception of the management team.102.2 Principles of good lendingPurposeWhere would the money lent be used?Amount.Is it reasonable ?Is it fit for purpose?Is the contribution by the borrower adequate ?Repayment.What are the terms and what is the certainty of repayment ?11The decision processRisk verses Reward.The company must consider whether the reward gained on lending is worth the risk.Some losses are inevitable however well-regulated the lending process is.This needs to be recognized and built into the pricing models.Due Diligence must be done!

122.3 SecuritySecurity taken is dependent on:The nature of the transaction underlying the borrowing.The covenant of the borrower.Market circumstances and the comparative negotiating strength of lender and borrower. What security is available.132.4 Credit ratingCredit rating is an indication of the credit worthiness of a company.Examples :International Examples include;Moody's, Standard and Poors.Local Examples include;Metropol Corporation , Global Credit Rating Company and Agusto and Company Limited.

143.Liquidity RiskThis is the risk that the individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at excessive cost.The context varies for:Non Financial Institutions.Insurance and Benefit Schemes.Banks.CIVs.How can liquidity risk be managed?

153.2 Market liquidity riskIn the context of the financial markets, liquidity risk is where a market does not have the capacity to handle (at least, without a potential adverse impact on the price) the volume of an asset to be bought or sold at the time when the deal is required.Difference between Marketability and Liquidity.Marketability is how easy it is to convert an asset into cash.Liquidity is a measure of how long it will take for an asset to become cash.164 Market riskThis refers to the risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates.The risk can be divided into:The consequences of changes on asset values (this is the most obvious implication).The consequence of investment market value changes on liabilities. The consequences of a provider not matching asset and liability cash flows.174.1 Asset value changesAsset value changes can result from: Changes in the market values of equities and property asset classes.They can be systematic or diversifiable.Changes in interest and inflation rates. Affects: Fixed-interest bonds.Index-linked bonds.Equities.Property.184.2 Liability value changesConsidered in context of company stake holders, policy holders and benefit scheme members.

The two causes of liability value changes are changes to: The liability amount, e.g. inflation-linked annuities or unit-linked benefits.The liability value as the interest rate used in the valuation changes.194.3 Asset / liability matchingThe fundamental principle of investment is that assets should be selected to match the liabilities in nature, term and currency.Not possible to find a perfect match due to:There may not be a wide enough range of assets available.Liabilities may include options and hence have uncertain cash flows after the option date.Liabilities may include discretionary benefits. The cost of maintaining a fully-matched portfolio is likely to be prohibitive.205 Business riskThese are specific to the business undertaken.Risk for insurance companies include:Claims.Withdrawals. Expenses.Mix of business.Volume of business.Options and guarantees offered.Reinsurance.216 Operational risk and external riskThis refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.Operational risks can be controlled or mitigated by an organization.Operational risk can arise from:Inadequate or failed internal processes, people or systems.The dominance of a single individual over the running of a business, sometimes called dominance risk.Reliance on third parties to carry out various functions for which the organization is responsible.The failure of plans to recover from an external event.226.2 External riskExternal risk arises from external events, such as storm, fire, flood, or terrorist attack. However the failure to arrange mitigation against such risks is an operational risk.In general these are systematic risks. Only for the largest entities is it economically efficient to diversify these by carrying out the same operation on different sites.23Summary24Questions???25Thank you.26