Enterprise Risk Management (Summer 2018)
Coursework
Please note that Coursework for this course is “Open Book” and includes questions that it would not be practical or reasonable to include in the end of course “Closed Book” exam. For example, for the exam, students are not expected to be able to recall detailed aspects of individual Case Studies or Regulatory Material covered in Course Sessions. However, they may be expected for Coursework to refer to such material where relevant.
Coursework Questions [Total marks: 50]
EIOPA’s “Guidelines on system of governance” (EIOPA-BoS-14/253) provide guidance on how EU insurers subject to Solvency II should structure their system of governance.
- Summarise the main policies that these guidelines require such firms to have, the features these policies are expected to exhibit, why EIOPA considers it important for insurers to have such policies and what sanctions are available to EU national supervisors if insurers they supervise under Solvency II fail to adhere to these guidelines.
[10 marks]
A UK retail bank has some customers to whom it has provided bank deposits (“index linked deposits”) with fixed 10-year terms where the amount paid out at maturity depends on movements in the FTSE 100 index between the date the deposit was first taken out and the maturity date, but is never less than 80% of the amount originally deposited. It has hedged some of the market risk exposures created by these deposits using centrally-cleared derivatives (including futures and options), but still has some residual exposure to equity market risk from this source, and some exposure to interest rate risk, credit risk and liquidity risk from other products it has provided to its customers. It uses an internal models approach when determining its Pillar 1 capital requirements.
- Describe why the bank might have decided to use both futures and options to hedge market risk exposures arising from the equity linked deposits its customers have placed with it.
[3 marks]
- Explain the main risks that central clearing of derivatives aims to mitigate and why policymakers have since the 2007-09 Credit Crisis made it mandatory to clear certain types of derivatives with central counterparties.
[4 marks]
- Describe how regulators typically now expect banks to manage and monitor their liquidity risks. [Hint, some material on liquidity risk monitoring is included in the BCBS paper “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools”.]
[7 marks]
The bank also markets “feeder funds” that allow its customers to gain exposure to investment funds provided by certain investment managers (in-house and third-party) selected by the bank.
- Explore risk measurement and management disciplines it would be wise for the bank to have in place in relation to such funds. [Hint, such funds were used by some intermediaries to gain exposure to funds run by Bernard L Madoff.]
[7 marks]
The bank is planning to purchase a UK insurance group that has a non-life insurance subsidiary specialising in providing motor and travel insurance and a life insurance subsidiary specialising in providing unit-linked insurance products, including some that have maturity guarantees.
- Set out reasons why the purchase of the insurer might:
- Be appealing to the bank
- Present challenges to individuals working in the insurer’s risk management function
[4 marks]
- By referring to the BCBS’s January 2016 paper “Standards: Minimum capital requirements for market risk”, or otherwise, review the role that stress testing might be expected to play in the bank’s capital management and compare or contrast this with how stress testing might be used by the insurer in its capital management.
[5 marks]
You work in the risk team of the life insurance subsidiary referred to above and you have been asked to model the rate at which it might suffer a specific type of operational risk loss. Your boss proposes that you assume the rate of occurrence of such losses follows a Poisson process, with a constant intensity , i.e.:
where = number of events that have occurred by time and is the probability of event occurring.
The number of such losses incurred over the last 5 years have been 4, 6, 1, 1 and 3 respectively.
- Apply the method of moments and separately apply the method of maximum likelihood to estimate given this model and this data.
[4 marks]
- Give examples of ways in which frequency and severity of operational risk losses might not be independent of each other.
[3 marks]
Your boss also asks you to model the rate at which a large counterparty of the insurer (e.g. one of its main reinsurers) might default, to help assess the credit risks to which the insurer is exposed.
- Give reasons why assuming a Poisson process as above might not be appropriate for such an exposure.
[3 marks]