RSK4803 EXAM PACK 2023

RSK4803 Exam Pack (1) 2 - Valsamakis Risk Financing (University of South Africa) lOMoARcPSD| RSK4803 CRUNCHTIME.TEACHABLE.COM Compiled by Lionel Jabu Munemo () EXAM PACK FOR 2019 EXAMS Downloaded by Thomas Mboya () lOMoARcPSD| Crunch Time Jan/Feb 2018 Downloaded by Thomas Mboya () lOMoARcPSD| First you need to calculate the E(X) and standard deviation. Variance =[(x i – E(X)] 2 Pr(x i ) σ(X) = R42,862.94 MPL Theft = R217,367.38 MPL (after multiplied with factor of 10) =R2,173,673.84 Question 1 Please read the Diamond Rush Case study in the Jan/Feb 2018 exam paper.If you do not have access to the past exam paper you can email your request to me-Jabu.My email address is 2 Solution The maximum probable yearly aggregate loss is that value that will equal or succeed in a stated proportion of all cases the total loss amount during a one- year period from a specified peril. Downloaded by Thomas Mboya () lOMoARcPSD| Depreciation of mining assets is not a cost of risk. The depreciation of the proposed generators is not relevant to the question as it is a project under consideration and not relevant to the discussion. Question 2 The CEO of Lucky Strike has requested you to calculate the cost of risk for 2016. Classify the cost of risk into the main components of the cost of riskand prepare a table of the total costr of risk for Lucky Strike for the next EXCO meeting.Show all calculations.(20 marks) 3 Solution lOMoARcPSD| • Alternative/Instrument • Characteristics of the solution • Total cost per solution • Expected advantages/disadvantages of the solution • Recommendation Solution Students were given leeway to argue to create capacity of 13.5MWh, or 7MWh, depending whether they can develop an argument for running the backup generators at full capacity over an extended period. Alternative 1: Option Strategy Raw Diamond is prepared to sell options with a strike of R1 8m per 1MWh. The premium is 10% of the strike price i.e. R18 000 per MWh. The most appropriate option is an American Call Option due to the following reasons: • Power interruptions are not planned, with the effect that Lucky Strike must be able to exercise the option and buy electricity from Raw Diamond at any time during the life time of the option. • The strike price and premium of the option is fixed for the life time of the option and there is thus no uncertainty on either one of the components. Lucky Strike will not incur additional cost to the premium, except if the option is exercised. The benefit for Lucky Strike is that no additional infrastructure needs to be installed and maintained. Should the national electricity grid become more stable, the reliance on additional power suppliers can be reduced. The cost to implement the solution for 1MWh will be as follows: Premium: R18 000 Exercise price: R 1 800 000 National grid price: R 1 550 000 The total cost to implement solution 1 will this be R18 000 + R250 000 = R268 000 per 1 MWh. Question 3 It is clear from the case study that power outages have had an adverse e ect on the production of Lucky Strike in 2016. Evaluate the two ff alternatives as stated in the case study and make a recommendation to the board regarding the most appropriate or combination of the alternatives to ensure business continuation. Your answer should include the following: 4 lOMoARcPSD| Alternative 2: Install additional diesel power generators Alternative 1 is recommended as it is the most effective method to fund electricity short falls.The current 6.5 MWh capacity provides additional resilience in the event of a power outage and should be retained. Lucky Strike should therefore not buy the additional generators.Students should also show that decision making can be applied to the scenario. 5 lOMoARcPSD| Solution The enterprise should also develop specific criteria to evaluate the retention funding strategy, by having a thorough understanding of their risk bearing capacity, cost of capital and risk appetite. 1-Evaluation of retention funding using the value of the enterprise criterion. The method of evaluating the superiority of retention funding is based on the effect that funding may have on the value of an enterprise. This criterion dictates that, should funding have a more positive effect on the value of the enterprise than other forms of financing, it is to be preferred over such other forms. To evaluate the role of funding, the value of the enterprise must be examined. The value of the enterprise at any point in time is: • the sum of the value of operations, plus • the value of investments. The size of the fund is important. If the size of the fund is too small to cover losses, the burden will have to be shifted to other forms of funding, including external financing with an associated increase in finance and transaction costs. If the fund is too large, it reduces the value of the enterprise because excess funds could have been invested in operations and earned a return. Transaction costs are an important aspect to consider when evaluating the case for retention funding. Delay costs such as issue and underwriting costs associated with raising new external debt or equity in the event of a large loss, as well as interruption costs due to time delays should all be regarded as part of the transaction costs. The effect that funding may have on the enterprise’s cost of capital must also be considered. Funding merely shifts the cost to another accounting label, and the enterprise remains exposed to the same riskiness of the retained losses. Question 4 Discuss the criteria to evaluate a retention program (15 marks) 6 Downloaded by Thomas Mboya () lOMoARcPSD| 2-Evaluation of retention funding under the assumption of no transaction costs. Under the assumption of no transaction costs, the value of the enterprise can be depicted as an equation where the enterprise’s value can be depicted as an equation where the enterprise’s value appears as the sum of: • the value of the commercial non-risk management activities of the enterprise and; • the value of the retention fund, reduced by; • the value of the enterprise’s loss exposure. The case for establishing a fund then depends exclusively on the relationship between the risk-adjusted return on the fund assets and the risk-adjusted cost of the fund. Value is only added if the risk-adjusted return on the fund exceeds the risk-adjusted cost. The above is not entirely valid as it is incorrect to assume that retention will result in no transaction costs. Retention is normally associated with, for example, staff costs, administration costs, cost of debt and platform costs for various retention instruments. By assuming no transaction costs, the value of the enterprise is overestimated, which could lead to a decision to retain when it might not be best to retain. It is best to assume transaction costs as it is more realistic and prudent. The conclusion is therefore that the case for establishing a fund is entirely independent of the enterprise’s loss exposure, hence there is no risk management case for establishing a retention fund under the assumption of no transaction costs. Evaluation of retention funding under the assumption of transaction costs commanded by alternative sources of finance Post-loss sources of finance may have associated costs such as underwriting and issue fees and cost of delays. By introducing transaction costs to the question, the value of the enterprise appears as the sum of: • the value from commercial (non-risk management) operations and • the value of the retention fund, reduced by • the loss exposure contribution and • the contribution from incurring transaction costs or unfunded losses. 7 Downloaded by Thomas Mboya () lOMoARcPSD| Therefore, with the likelihood of transaction costs, the value of the fund is dependent on the loss exposure. There is thus a risk management case for establishing a retention fund. Therefore, in conclusion, the absence of frictional costs, the effect of a possible favorable loss experience, the timing of cash outflows, and the possibility of earning more than the cost of capital on the retention fund, makes retention funding more appropriate than insurance from a value of the enterprise perspective, even in the absence of transaction costs. 8 lOMoARcPSD| Solution “Insurance securitization” can be defined as the transferring of underwriting risks to the capital markets through the creation and issuance of financial securities. In particular, the insurance securitization process involves the following two elements: •The transformation of underwriting cash flows into tradable fin a n c i a l s e c u r i t i e s . •The transfer of underwriting risks to the capital markets t h r o u g h t h e t r a d i n g o f t h o s e securities. It is selling the rights to cash flow from loans etc. 9 The Securitization Process Selection of assets by the Originator • Packaging of pool of loans and advances (assets) • Underwriting by underwriters. • Assigning or selling to of assets to SPV in return for cash • Conversion of the assets into divisible securities • SPV sells them to investors through private stock market in return for cash • Investors receive income and return of capital from the assets over the life time of the securities • The risk on the securities owned by investors is minimized as the securities are collateralized by assets • The difference between the rate of the borrowers and the return promised to investors is the servicing fee for originator and the SPV . • Assets to be securitized to be homogeneous in terms of underlying assets ,maturity period ,cash flow profile Downloaded by Thomas Mboya () lOMoARcPSD| The role of Participants in the structure • Originator : An entity making loans to borrowers or having receivables from customers • Special Purpose Vehicle : The entity which buys assets from Originator and packages them into security for further sale • Investment Bank : A body that is responsible for conducting the documentation work. • Credit Rating Agency : To provide value addition to security • Insurance Company / Underwriters : To provide cover against redemption risk to investor and / or under- subscription • Obligors : Company that gives debt to other company as a result of borrowing.( debtor) • Investor : The party to whom securities are sold 10 lOMoARcPSD| Solution Insurance Linked Securities Insurance-linked securities (ILS) are an innovative way of increasing insurance capacity.The ILS market enables insurance companies to transfer risk to the capital markets in times of capacity shortage. There is no counter-party risk as there is with traditional reinsurance. The funds are held in a safe, bankruptcyremote SPV. However, with an index or parametric trigger there is basis risk — the difference between actual losses of the insured party and the losses implied by the index or parametric trigger. Investors tend to prefer index and parametric triggers because they mitigate moral hazard. For insurers, these triggers eliminate the need to reveal details of their book of business to outside parties. Structured Finance Structured finance is used here to refer to asset-backed securitization of future cash flows from credit card receivables, mortgages, automobile loans, etc. Whereas the markets for some asset-backed securities, such as mortgage backed securities, are highly developed and very liquid, there is also a market for less well-known asset classes. Corporations utilizing structured finance usually transfer their assets to a special purpose vehicle (SPV) created for this purpose. To pay for the assets, the SPV raises capital from the investors in the capital market. Life Insurance Securitization Life insurance securitization is also a segment of the ILS market. Mortality and longevity risk securitization fulfill a similar function for life insurers, as catastrophe bonds and sidecars do for property/casualty insurance and reinsurance companies-the transfer of risk to the capital markets. Side Cars Reinsurance sidecars, conventionally referred to as "sidecars", are financial structures that are created to allow investors to take on the risk and return of a group of insurance policies (a "book of business") written by an insurer or reinsurer (henceforth re/ Question 6 (20 marks) 11 Downloaded by Thomas Mboya () lOMoARcPSD| insurer) and earn the risk and return that arises from that business. A re/insurer will only pay ("cede") the premiums associated with a book of business to such an entity if the investors place sufficient funds in the vehicle to ensure that it can meet claims if they arise. Typically, the liability of investors is limited to these funds. These structures have become quite prominent in the aftermath of Hurricane Katrina as a vehicle for re/insurers to add risk-bearing capacity, and for investors to participate in the potential profits resulting from sharp price increases in re/insurance over the four quarters following Katrina. An earlier and smaller generation of sidecars were created after 9/11 for the same purpose. 12 lOMoARcPSD| May/June 2018 Crunch Time Downloaded by Thomas Mboya () lOMoARcPSD| Solution (a) To minimize the cost of risk, the following should be considered: • Adoption of a long-term view of when cost to benefit trade off related to the levels of risk control expenditure • Risk control should be undertaken within the limits dictated by broad corporate financing objectives and constraints • Risk financing decisions should be taken with due reference to the investment decision When considering these costs any business should aspire to achieve these three risk management objectives: • Financial : to reduce the ratio of total cost-of-risk and to maintain the improvement over a sustained period. • Resources : to conserve assets and preserve the physical health of employees through safe working habits and safe working environment. • Customers and the public : to improve the enterprise’s image among the people it serves through the reduction of accidentcausing conditions that affect the product it makes and the services it delivers. (b) The cost of risk concept was developed as a measure to report results of the risk and insurance management function. The components of the cost of risk consist of: • Insurance cost • Unreimbursed losses • Risk control and loss prevention expenditure Question 1 14 lOMoARcPSD| • Administration cost Insurance Costs Direct insurance costs – directly related to the total of all insurance premiums. Other aspects must be considered to decide the actual cost of insurance. These include opportunity cost of the funds spent as insurance premiums. The tax implications of premiums and claims, and the cost of capital relative to the value of the expected claims. Costs of statutory insurance – e.g. Worker’s compensation and unemployment insurance but reduce the cost by claims recoveries. Opportunity costs The rand value spent on insurance premiums that could for example, have been spent on improving the production line or invested in the production process thereby generating more profit for the firm. The opportunity of those additional profits is lost due to having to spend the money on insurance premiums. Unreimbursed losses or self-insured, self-retained Can arise from the following: • Excesses provided for insurance policies. • Inadequate sums insured. • Breach of policy conditions or warranties contained in policies and the consequent forfeiture of insurance protection. • Losses resulting from risks against which there is no available insurance cover, although the risks are known. • Losses that are uninsured either intentionally or unintentionally. • Uninsurable losses. • The insolvency of the insurer Risk control and loss prevention expenditure Includes the following: •Depreciation on major capital costs to reduce risk, e.g. depreciation following the installation of a sprinkler system. •The cost of time consumed in the identification and evaluation of risk, including the cost of outside consultants, if appointed. •Ongoing operational and procedural expenses for risk control measures such as security guards, maintenance of fire equipment and cash carrying services. 15 Downloaded by Thomas Mboya () lOMoARcPSD| • Risk control training costs/seminars/courses. •Subscriptions to safety, security and risk management societies, journals, etc. •Management time taken up by risk-control and risk-financing (insurance) meetings. Administrative expenses Expenses include the following: •Clerical costs in handling of insurance matters. • Cost of handling self-insured losses. •The cost of reporting and investigating loss occurrences. •The cost of an in-house risk management department. •The cost of a risk management broker if applicable. 16 lOMoARcPSD| Solution (a) Unfunded risk retention A risk is retained and unfunded when no specific provision is made for the financial consequences of the loss. Not providing funding for risk is the most common risk financing method, mainly because of the range of risks the enterprise is exposed to. Although this discussion is mainly focused on the retain or transfer decision, implementing systems, processes or additional personnel to manage/reduce the risk profile of the enterprise forms part of the cost of risk as pointed out in the previous topic. Unfunded retained risks can be divided into two broad categories: • risks that are insurable, but retained •risks that are uninsurable Risks that are insurable, but retained, are normally the high frequency, low severity losses, for example, each and every excess on motor losses. Often risks are not funded because funding it through insurance may far exceed the perceived benefit to the insured, e.g. the risk of an earthquake in South Africa is small and therefore risk managers may decide not to insure the risk or make provision for it. Funded risk retention Where an enterprise is in a position to fairly accurately predict certain losses and estimate their annual cost, an amount can be paid into a fund and in this way predicted losses can be economically retained. The fund represents a form of pre-loss financing into which contributions are paid and from which withdrawals are made following a loss. This is known as funded risk retention (and preferably not ‘self-insurance’, since the term ‘insurance’ normally involves pooling or transfer of risk)