ERM FINAL EXAM QUESTIONS AND ANSWERS

what is the goal of ERM? - to manage individual businesses within overall business portfolio what are the 4 benefits of active portfolio management? - 1. UNBUNDLING in terms of risk origination, retention, and transfer 2. RISK AGGREGATION across the whole company 3. setting RISK LIMITS & ASSET-ALLOCATION TARGETS 4. influencing TRANSFER PRICING, CAPITAL ALLOCATION, and INVESTMENT DECISIONS explain: UNBUNDLING in terms of risk origination, retention, and transfer - management can decide where within the value chain it should compete by considering its core competencies & risk/return economies explain: RISK AGGREGATION across the whole company - the risk portfolio = all the risks within the company management needs this info & how they relate to each other in order to set limits & targets explain: setting RISK LIMITS & ASSET-ALLOCATION TARGETS - complementary controls for optimal risk/return for the businessexplain: influencing TRANSFER PRICING, CAPITAL ALLOCATION, and INVESTMENT DECISIONS - allocate more $$$ to businesses/products with better risk/return explain the WindGuard case study - insurance companies, in addition to conducting normal insurance business, also often have publicly traded equity - thus, shareholder happiness is important to them. when the insurance company's risk profile is greater than desired, they can purchase REINSURANCE (which is insurance for insurance companies); this is important because insurance is very risky already. the value of an insurance company is in its ability to forecast risk & price contracts well - any leftover $ is profit. hurricane Andrew was an example that a severe natural disaster could bankrupt a company if they are unprepared to payout. in this case: WindGuard, a FL insurance company, specializes in providing insurance to homeowners against damages caused by natural disasters. Historically, they had performed well due to mild-weather and well-priced contracts. Management is concerned that the weather would get worse in the years to come; they worried about loss volatility and not being able to pay out. While WG still has expected return/profit amount - the risk is now greater than the company can afford. Thus, a possible solution is PURCHASING REINSURANCE; although this will reduce the net expected return (since the reinsurance protection has a price), it will significantly reduce the company's risk (unpredictable --> more predictable, smaller counterparty risk of its reinsurers).This is a good solution - WG is willing to have a smaller return and significantly smaller change of bankruptcy instead of having a higher return with higher chance of bankruptcy. explain the WidgetCo case study - shareholders prefer earnings stability as opposed to earnings volatility; when given a choice, they will always pick the safer, less risky investment. and, companies do have a good amount of control over their risk generation level. in this case: WidgetCo is a U.S. based company who historically has made its SHs happy because of its increasing revenue & earnings growth; they are going to start conducting global business in Japan for the first time they are worried about FOREIGN EXCHANGE RISK - that it will add considerable UNCERTAINTY to future revenue flows. the Japanese customers don't want to account for the difference between the value of the yen/$ - EXPOSES THE COMPANY TO THE RISK THAT THE VALUE WILL CHANGE AND THE PROMISED REVENUES WILL BE LOWER THAN PROJECTED (prices are decided before production starts - aren't paid until delivery though) they have a few options: 1) do nothing - everything will go as planned - UNLIKELY 2) MORE LIKELY - exchange rates will deviate have to look at what the SHs view of the company is: if favorable - SHs will be excited initially , but it won't lastif unfavorable - will create uncertainty & SHs will likely lose confidence in the company BEST DECISION - cannot taken on the additional risk of doing business - WidgetCo should hedge against the foreign exchange rate - & enter into forward contracts ('contract arrangements with 3P to exchange at a fixed amount of currency at a predetermined exchange rate') in order to remain a reliable business case studies illustrate.. - a business should decide whether to seek 3rd party protection against risk self-insured retentions (SIR) a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks risk retention groups (RRG) a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks captives a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks rent-a-captives a) unconventional vehicles used to cover conventional risksb) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks earnings protection a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks finite insurance a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks integrated risk & multi-trigger policies a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks multi-year, multi-line policies a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - a) unconventional vehicles used to cover conventional risks insurance-linked bonds a) unconventional vehicles used to cover conventional risksb) vehicles based on instruments from the capital markets - b) vehicles based on instruments from the capital markets securitization a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - b) vehicles based on instruments from the capital markets cat-e-puts a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - b) vehicles based on instruments from the capital markets contingent surplus notes a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - b) vehicles based on instruments from the capital markets credit default swaps a) unconventional vehicles used to cover conventional risks b) vehicles based on instruments from the capital markets - b) vehicles based on instruments from the capital markets weather derivatives a) unconventional vehicles used to cover conventional risksb) vehicles based on instruments from the capital markets - b) vehicles based on instruments from the capital markets 3 types of market risk - 1) trading 2) asset/liability mismatch 3) liquidity 3 flavors of VaR - 1) parametric (variance-covariance) approach 2) monte carlo simulation 3) historical simulation a) what is gap analysis? b) what are limitations of gap analysis? (2) - a) gap analysis is a common technique for measuring interest rate risk. the organization's assets & liabilities are grouped into time buckets according to when they will be re-priced; the difference between repricing assets & repricing liabilities is known as the gap. b) limitations: 1) ignores mismatches that exist within the various time buckets 2) usually not an effective tool for more complex interest rate risk factors GAP ANALYSIS: when repricing liabilities > repricing assets --> - negative gap - indicates risk exposure to increasing rates 3 emerging IT risks - 1) cyber security 2) cloud computing 3) social mediaexplain emerging IT risk: cyber security - cyber security is the greatest threat to national security. there is an increasing amount of cyber criminals & their methods keep getting more sophisticated - so companies need an effective ERM that focuses on mitigating the damage done by the attack (getting rid of all the risk of attacks is out of the firm's control). the best method to combat: work with other firms. the constant advances in technology make cyber crime a challenge - thus ERM should be flexible & constantly updated. explain emerging IT risk: cloud computing - allows firms to reduce OH costs by reducing capital to invest in physical storage. but it doesn't eliminate risk - creates a new set of risks due to lack of control over the firm's data, such as data leakage. firms should apply risk management strategies such as a risk appetite statement. explain emerging IT risk: social media - social media impacts the relationship between employees & companies and obscures the lines between personal & corporate boundaries.