Applying Risk Management

Process of Risk Management:

Envision
process

control risk identify risk

communicate

plan
assess risk
strategies

Generally, risk in enterprise divided by:

Business risk: those which are directly related to product sold by the company
Non-business risk: not directly related to the product sold. Related to running the business in
general. Include event risk and financial risk.

product risk
business risk macroeconomic risk
technological risk

legal risk
entrprise-wide
risk reputational risk
event risk
disaster risk
regulatory risk

non-
business market risk
risk
credit loss
liquidity risk

financial risk

operational risk
foreign exchange
Risk management process
Following will describe in detail each step of risk management process

1. Identify risk

objective methodology Deliverable

Brainstorm
Focus group discussion
Identify and Statement of
Interview
prioritize key risk prioritized risk
Periodic risk reporting
Surveys

Before we can manage risk, we must identify them. At this stage of process we must also
prioritize the risk. It is also important to note that risk mitigation techniques are used to
manage risk. However is many case, risk mitigation is not simply remove the risk.

Identification and prioritize of risk begins with the gathering of information from individual
employees/team member of their concern, uncertainties or issue regarding the entity or process
under review. These review should be supplemented with feedback from relevant stakeholder.

A unique risk identifier should be assigned to each risk along with a clear statement of risk that
describes:

The circumstances causing uncertainty

tangible outcome of that uncertainty
any risk dependencies within entity or process

A. Insurer risk
Identifying insurer risk
Major of
Sub risks:
insurance risk
Included in product risk (in enterprise risk classification). The risk generally
fall into underwriting risk:
underwriting process risk: related to selection and approval
pricing risk: price charged is actually inadequate to support future
obligation
product design risk: risk which not anticipated in the product design
or insurance contract
underwriting risk claim risk (for each peril): many more claim occur than expected
economic environment risk: environment will change has an adverse
effect to the company
net retention risk: higher retention of insurance loss due to
catastrophic or concentrated claim experience
policyholder behavior: policyholder act in way has adverse effect to
the company
reserving risk: provision held for policyholder obligation will prove
to be inadequate.
 In general means the risk of default change in credit quality of issuers of
securities, counterparties, or intermediaries to whom company has an
exposure. Credit risk include:
business credit risk: counterparty fails to meet the obligation,
include reinsurer fails to meet obligation to the company
credit risk invested asset credit risk: risk of non-performance of contractual
payment obligation or adverse change in credit worthiness of
invested asset
political risk: change in government policies that affect
creditworthiness of financial instrument held by insurer
sovereign risk: adverse change in creditworthiness of securities
issued by government or government entities
Market risk arises from level of volatility of market price of assets. Market
risk include:
interest rate risk: losses due to interest rate fluctuation
spread risk: fluctuate of interest rate
equity and property risk: loss resulted from market value fluctuation
of equities and other assets
Currency risk: change in currency decrease in currency value of
foreign asset or increase value of obligation denominated in foreign
currencies.
Basis risk: yield on instruments of varying credit quality, liquidity,
market risk
and maturity do not move together, thus exposing the company to
market value variation that is independent of liability value.
Reinvestment risk: return on fund to be reinvested will fall below
anticipated
Concentration risk: increase to exposure to loss due to concentration
of investment in a geographical area or economic factor
ALM risk: fluctuation of interest and inflation rate have different
effects on the value of asset and liabilities
Off-balance sheet risk: risk of change in value of contingent assets
and liabilities such as swaps that are not otherwise reflected in the
balance sheet
The risk which associated with event such as fraud, system failure, litigation
or regulatory breach within the company. Operational risk include:
human capital risk: not be able to maintain sufficient well-trained
personnel
operational risk management control risk: insurer fail to have appropriate
management discipline or internal control
system risk: computer system failure impair the company ability to
conduct business
strategic risk: company inability to implement appropriate business
plan.
Liquidity risk the exposure to loss in the event that insufficient liquid asset
will be available from amongst asset supporting policy obligation when they
are due. Liquidity risk include:
liquidation value risk: unexpected timing amount of cash needed,
liquidity risk causing liquidation of asset which result in loss of realized value
affiliated company risk: investment in affiliated company may be
difficult to sell. Or affiliated company may drain financial or
operating resource
capital market risk: company could not be able to obtain sufficient
funding from capital market
strategic/event Risk outside control of company which has significant adverse impact. Event
risk risk include:
 legal risk: adverse judgment which affect operation of
company
reputation risk: negative publicity to customer (true or not)
causing decline in revenue
disaster risk: external major event (missal: earthquake)
that cause system failure which unable company operate in
orderly manner
regulatory risk: negative legislative, court decision, tax
change which alter market or competitive ability
political risk: action by government will impact company to
conduct business
Risk which distribution channel expose the business. Distribution risk
include:
volume of business sold: low sales volume cause high cost per sale.
However if company create strain, high volume also risk.
Distribution risk nature of business sold: distribution is the entry point of this risk,
which will be reduce if the distribution channel likely to reach the
right customer
reputation/compliance: many of compliance issue which company
reputation arise around the point of sale
Expense are too high and has adverse effect to profit. This risk can be
Expense risk managed by combination of: budgeting, expense control, expense analysis
(gain understanding what drivers the expense and specific cost cut project).

It can be challenging to identify the TRUE source of risk. For example, adverse underwriting
experience could be due to a variety source of:

incorrect pricing
risk profile of business assumed varying from that assumed in pricing
underwriting practice actually used varying from those expected in pricing
actual risk experience of the business assumed varying from that assumed in its pricing
faulty claim management

Additional specific risk to each specific insurer:

Specific insurer Additional risk

because product offered often long term in nature, there could
be a risk that:
claimable event will be obsolete. For example due to medical
technology cause lower price of surgery.
Reinvestment risk. Since the contract may have a single or fixed
Life insurance
premium, even though suitable asset with sufficient duration to
match future obligation are not available when the policy sold.
Change in policy holder behavior. For example withdrawal behavior
Longevity risk. Unique to life insurer which sold retirement income
product
Health insurance usually sell short-tail insurance product which the claim
settled quickly. In many case there is little scope or no underwriting apply for
each person.
Health insurance
Unique risk: anti-selection risk. Occur when person with better health opt for
cheaper or less coverage, while those poorer health will remain covered and
insensitive to premium change.
 General insurance provide wide coverage, usually one year tem, coverage is
high-frequency and low-severity. Important specific risk are:
Volatility risk: total amount of claim is differ from its expected value.
Caused by randomness of frequency, severity, and time to payment of
claim related expense.
Uncertainty risk: divided into
o Parameter distribution used are prone to misestimation
o Parameter driving the claim process are not constant over
time
General insurance
o Chooses distribution and other model assumption are not
correct
Extreme event: event occurring with low-frequency and high-severity,
cannot be estimated. Usually insurer relies on reinsurer to manage
this.
Super-imposed inflation: this is specific risk for long-tail business,
long-tail claim which need long time to settle. This kind of claim can
be significantly affected by super-imposed inflation, lead to extra
growth of claim cost.

B. Superannuation risk
Risk can arise from any part of the management of superannuation fund, including

o Plan design
o Investment strategy
o Asset selection and allocation
o Asset liability modelling
o Plan valuation
o Plan administration
o Member education
o Compliance and tax filling
o Financial management
o Performance assessment
o Plan funding

Basic form of
superannuatio Risks
n fund
Main objective of DB is provide reasonable benefit at reasonable cost
(employers contribution rate). Major risk faced by employee is highly
related with his career with employer. We consider employer risk is that the
cost of fund is excessive and affect viability to sponsor DB. This maybe
Defined benefit happen due to experience in:
(DB) fund Poor investment performance
Salary inflation
Pension inflation
Pensioner longevity: higher than expected rate of mortality
Other significant experience not listed above
Defined By fixing the contribution rate, the impact of adverse experience will fall on
contribution (DC) the member of a DC fund. The member should manage this in a similar way
fund with the employer.

C. Fund management risk

 Source of income: difference between fee income and expenses. Key driver of fee income is
fund under management (FUM). Growing FUM, drivern by:
Inflow: new fund or existing customer increase fund
Outflow: customer withdraw or transfer fund to another
Investment performance: growth in investment, whether income or capital gain,
increase FUM

Key risk:

Asset offer potential additional return also have downside risk

Pursuit of extra performance demanded by customer may lead investment manager
invest in asset which are not allowed under investment mandate. However, loss of
customer is also significant risk, if the investment is below customer expectation

D. Banking risk
Typical type of business within a global bank include: domestic banking, international
banking, capital market

Bank type Dominant risk

This bank focus on segment retail, small business and commercial.
Dominant risk is credit risk inherent with loans of all type
Domestic banking (mortgage, credit card, commercial loan, etc).
Key challenge: maintain an adequate spread between interest
earned on asset vs that paid out the liability (demand on deposit)
International Risk for domestic bank also apply and additional currency risk
banking from conducting foreign operation.
Focused on corporate loan, derivative, investment banking.
Subject to:
Warehouse risk: risk of loss it has created but cannot be
Capital market sold to investor
Underwriting risk: risk of loss through providing a
guaranteed price when new securities are underwritten
and issued publicly

Risk face generally by banks:

Credit risk
Market risk
Operational risk
Liquidity risk
Strategic/event risk

2. Risk assessment

objective methodology Deliverable

Assess exposure to loss Qualitative models Understand of gross and
from key risk Quantitative models net risk exposure
Understand risk Develop risk model for
 dependencies scenario testing

a) Qualitative vs quantitative
Preferably can quantify frequency and severity of each risk, but sometimes not practical
for some risk. In that case preferably using qualitative method (e.g. risk heat map). Special
for credit risk, usually assessment conducted using sophisticated model using amounts of
experience data.

b) Experienced data
If the business does not have sufficiently credible data of its own, it may be
appropriate to consider relevant industry or market data
Sufficient/credible volume of loss experience can also be gained by using a longer
study period.
c) Risk Model
Used for:
Valuation of insurer liability
Financial condition analysis
Stress and scenario testing
Analysis of asset/liability management
Pricing of insurance product
Evaluation of reinsurance program
Evaluation of various management strategies

In the design of a risk model, it is important to have a framework for risk management
with:
Time horizons: necessary to define the time horizon over which extremely
adverse experience is assumed to be occur
Risk measure: is a numeric evaluator to help determine the financial impact of
the risk. The risk measure that exhibit several desirable properties for various
(but not all) risk is TailVar. In many situations, the risk measure is better suited
to insurance risk than TailVar.
Confidence level: will depend on specific use of the model, time horizon, and
choice of risk measure.
Terminal provision: must be calculated whenever the time horizon is shorter than
the lifetime of the insurers obligation.

3. Risk treatment

objective methodology Deliverable

Execute the optimal risk Project implementation bets Action steps for executing
management strategy practice strategy including goals,
responsibilities, resource,
reporting, scope, schedule, etc.

Strategies for managing risk fall into the following major categories:
strategy Description
avoid Eliminate, stop, prohibit or sell risk exposure.
Some reason for seeking to avoid certain risk are:
Reason
Within the risk appetite set by board? No
Within the strategic plan developed by
No
senior management?
Sufficient financial capacity (eg capital
no
and liquidity) to withstand the risk?
Enough internal source to identify,
No
assess, and treat the risk?
Have appropriate process to identify
inappropriate risk management decision no
early
retain Accept and self-insure the risk exposure, eg by integrating it with other
risk or by diversification.
Reason why retain the risk
Reason
Within the risk appetite set by board? Yes
Within the strategic plan developed by
Yes
senior management?
Sufficient financial capacity (eg capital
Yes
and liquidity) to withstand the risk?
Enough internal source to identify,
Yes
assess, and treat the risk?
Have appropriate process to identify
inappropriate risk management decision Yes
early

Benefit of retaining the risk:

Diversification: can be achieved if the risk considered are
uncorrelated
Economic of scale: focus on similar business can be one of
assistance in developing focused business strategy
Reduce Mitigate or cap portions of the risk exposure. Business can reduce their
risk exposure in the event that the inherent risk retained is beyond
their risk tolerances. Risk reduction can be accomplish by:
Disposition/sale: sale part of the business
New business reduction
Transfer Insure, hedge, securitize or outsource the risk exposure. Transfer risk
can be done by:
Sharing experience with customers. For example part of
insurance feature depend on the market of investment
performance (in unit link)
Hedging: using derivative to offset market risk
Special purpose entity: a legal entity used for a specific
business purpose while protecting the parent entity from
excessive risk.
exploit Expand and diversify the risk exposure.
reinsurance Reason to buy reinsurance:
Increasing new business capacity
Limiting catastrophic claim
Limiting total claim
 Transferring investment risk
Gaining product expertise
Gaining underwriting advice
Diversity a product line
Financial result management