1

i)

Currency risk

As all of the reporting is done in the domestic currency of P-Land, any change in the exchange rate would
automatically have an impact on the P&L even if the underlying cashflows themselves are unchanged. As both
income and expense will be hit by the change in the exchange rate the benefit or loss is dependent on the
weightings of revenue and expense that are denominated in SFX. If the revenue is larger then a fall in PFX
against SFX would have an adverse impact on the P&L.

There is also a trading risk associated with this if there are any outstanding balances to be paid to suppliers, if
the exchange rate changes this could result in a higher or lower payment depending on the direction of the
currency movement.

Solvency Risk

If the assets are revalued due to a change in the currency the balance sheet and solvency will be at risk. This
could be a positive or a negative depending on the direction of the currency movement and the split of the assets
and liabilities between SFX and any other currency.

Liquidity risk

If the value of the cash holdings fall because of a movement in the exchange rate there could be a liquidity issue
for cashflows that do not fall in line with the fall in bank balances (payments to suppliers in PFX for example)

Business risk

If the trade agreements go poorly, the result could be that P-Land is no longer able to trade with S-Land. As S-
Land makes up a material proportion of the revenue this could cause PlainSailingCargo to have to find another
trading partner. The shipping industry is very competitive and relationship management is key, by losing an
entire county this could damage the income and challenge the business model.

Operational Risks

An increased Trading tariff could make trading in S-Land unaffordable, this could force PlainSailingCargo to
seek out another market or to reduce the volume of trade going through S-Land.

Another country would have to be found to trade with, this could result in increased fuel costs if it is further
away.

New suppliers would have to be found, particularly for fuel which is currently denominated in SFX. Fuel is a
key expense and the negotiations with a new supplier could increase costs.

There may be a sharp drop in trade as new agreements are negotiated. The business should make sure that there
is sufficient liquidity to meet short term payments. This could also include retaining staff and paying them
whilst there is reduced income.

Some staff may have to be made redundant if the level of trade falls, this will have to be carefully managed to
avoid any reputational risk.

ii)

The benefit of hiring a consultancy firm is that they should be subject manner experts. They are likely to have a
broader knowledge of how trade agreements will impact the wider market and how they could impact
PlainSailingCargo specifically. It is unlikely that the risk function within PlainSailingCargo will have the level
of knowledge and expertise to conduct this activity.
The downside is that there is an additional cost associated with this work, this could be difficult to justify if the
expectation is that the trade agreements could result in a loss of business, causing liquidity problems.

There is also the risk that the consultancy doesn’t fully understand how the business is set up and the value of
assets that it has. The consultancy should rely on the business experts to understand how the firm would react in
each situation and the ease with which they can do this.

There is a risk that the consultants make a mistake and don’t create an accurate scenario or a scenario that is
severe enough for the real world. There could also be a random error that is not spotted in the production of the
report that could understate a risk.

The Board or CEO could choose to ignore the consultancy report even if it is accurate.

iii)

A 5% scenario is a fairly common scenario to include in a report, this reflects a 1-in-20 scenario. When this is
compared against the stresses imposed under Solvency II, a 1-in-200, the scenario proposed is more realistic.

It is often worth including a black hat scenario to represent the worst case, even if it is unlikely. If the
consultancy has dubbed this the worst-case then it will be useful for the board to see how bad it could get. If the
business can show that it remains solvent under this scenario then it is almost certainly able to remain solvent
under all other scenarios. This will help to give the board proof that the trade agreements are not material.

The CEO may not have detailed knowledge of how the trade agreement between the 2 governments is
progressing but may see this large number as outlandish and unrealistic before giving it some thought.

The CEO should not be determining what is and isn’t included in an independent report for the Board. There are
other Board members who could be very interested in seeing this scenario.

The mitigation action against this risk is very challenging, reserving is unlikely to be suitable due to the low
likelihood high severity event. This could be a reason why the CEO has asked for this scenario to be removed
from the report.

The scenario could be changed to remove the indefinite time period, which could be causing a large impact on
the balance sheet. If a time was set where the trade agreement would return to normal levels the impact could be
more reasonable.

iv)

The PlainSailingCargo could reduce its indirect currency exposure by reporting in the currency where the largest
cashflows, or asset holdings, are incurred. This would reduce the translation risk.

PlainSailingCargo could reduce the creditor and debtor payment periods. If the length of time between paying
and receiving payment obligations in foreign currencies is reduced, the overall exposure will be reduced.

PlainSailingCargo could also engage in agreements with their suppliers and customers to meet all payments in
PFX, this would shift the currency exposure onto the counterparty.

PlainsailingCargo could hold assets in the same currency as the cashflow to ensure matching of the cashflows.

PlainsailingCargo could purchase derivatives to hedge against the market movements and offset the exposure.

v)

Counterparty Risk
By purchasing a derivative from plain bank there is a risk that the bank defaults on their end of the contract.
This would cause the derivative to default and PlainsailingCargo would have to meet their payment obligations
from other sources. This risk could be mitigated by choosing multiple banks to engage with and setting exposure
limits to each of the counterparties.

There is a risk that the change in trade agreements could impact the value of the derivative contracts and could
make them unaffordable for PlainsailingCargo.

Liquidity Risk

The bank may require a daily stream of payments to balance the derivative contract if PlainsailingCargo wants
to reduce the day-to-day fluctuations. This will force PlainsailingCargo to hold more liquid assets to ensure that
these payments can be made. This could be mitigated by converting some bonds or equities into cash holdings.
Shareholders may not like this as it will impact the expected future growth of the company and shareholder
value.

vi)

If the risk function are involved, they can review the derivative contracts and ensure that they are affordable for
the company.

They can set exposure limits on each counterparty

They can create KRIs on the derivative contracts based on the movement in the underlying. If the spread gets
too large the company could consider defaulting on the agreement.

The risk function could provide some modelling expertise and try and find offsetting balances internally before
derivatives are purchased. Internal Hedging.
3

i)

There are many similarities between Basel II/III and Solvency II

Both legislations set out requirements using 3 Pillars. Each of these pillars deal with a similar aspect of a
company’s risk

Capital – MCR and Quantitative requirements

Supervisory – Supervisory review and Qualitative requirements

Disclosure – Markey Discipline and Disclosure

They are both largely risk based, capital is allocated to the business areas with the higher risk. They both deal
with embedded options, guarantees and other non-value related risks.

They are designed to suitable for multinational firms and they are designed to allow firms that operate in
multiple sectors to manage risk in a consistent manner.

Different risk ratings are applied to different assets under Basel which is similar to the market risk component of
SII.

ii)

SII has 3 Pillars

1. Quantitative Requirements

This can be standard formula approach or an internal model.

It includes a Solvency Capital Requirement, if free assets fall below this level regulatory action is taken.

It also includes a Minimum Capital Requirement, if free assets fall below this level authorisation from the
regulator is foregone.

2. Quantitative requirements

Focuses on undertakings such as risk management as well as supervisory activities.

This includes an ORSA for SCR and MCR, as well as identifying any risk management processes and controls
associated with the business.

3. Disclosure

The includes all supervisory reporting and disclosures (SFCR and RSR)

Solvency II is based on a VaR approach on a 1in 200, 99.5%, scenario over a 1-year time horizon for all
individual risk drivers. These risks are then aggregated using correlation matrices to allow for a diversification
benefit. This forms the SCR. Layered on top of this is the risk margin which applies an additional capital
holding to non-hedgeable risk.

iii)

Assuming that LongLife uses a standard model:

Equity

As the equity index has risen by 15% over the quarter, we are going to see approximately a 15% increase in the
value of the equities on the asset side of the SCR stress. If the products are unit linked and matched this will
impact both the asset and the liability side evenly and the capital requirement will increase by 15%. If the
business is not matched and the value of the liabilities is not matched against an equity index, then the assets of
the company will increase in value and the equity risk will decrease.

The increase in equity index would act to increase the stress applied to the equity exposure (39%/49%
+symmetric Adjustment depending on Type I vs Type II equities), the level to which this increases is dependent
on how the index has changed over the last 3 years.

Assuming that there is no perfect matching and the asset exposure to equities is larger than the liability exposure
to equities we should see a reduction in the equity risk proportion of the SCR. The symmetric adjustment will
offset some of this by increasing slightly due to positive equity growth, but the overall result should be a
reduction in the equity risk component by c.15%. This will be diversified within market risk and then again
within the overall SCR calculation so the overall reduction in SCR is likely to be smaller than this.

Inflation

As inflation is growing by more than forecast it is likely that the expense risk component of the underwriting
risk module will increase. The change in the inflation will result in the modelled increase in expenses being
higher than expected and more capital will be assigned to this module. This could be large depending on the
gearing ratio within the projection. The expense stress includes an increase in the underlying inflation, this will
widen the margin and assign more capital to Expenses. This will also impact on the VIF used in the solvency
calculation, an increase in expenses will result in a reduction in VIF and a reduction in Free Assets. As this is a
non-hedgeable risk there will be an associated increase in Risk Margin with this change. The impact on the
insurance products here is likely to be largest as they are typically of a longer duration.

If the insurance contracts are designed to grow with inflation, this could cause the value at risk to increase
resulting in an increase in the liability value within the calculation. This could cause an increase in all modules
of the SCR, this increase could be fairly substantial.

Credit Spread

With credit spreads closing the gain that can be made over and above the risk-free rate is reduced. This is likely
to impact on both the assets and the liabilities as the insurance policies are likely to be linked to some
underlying metric. The benefit to assets is likely to be smaller than the impact on liabilities as only a proportion
of the assets are held in bonds. So, the overall impact on Market risk is likely to be an increase. This impact will
be diversified twice so the impact on overall SCR will be reduced, however this is a large shift and the business
could be highly exposed resulting in a large SCR impact.

Property

The value of the assets in property have increased and the expected future value will have also increased
because of the reduction in repossession rates. This will increase the value of the assets and is unlikely to have a
significant impact on the value of the liabilities, the value of the benefit in policies is unlikely to be linked to a
property value. This will have a positive impact on the Property exposure and result in a reduction in Market
risk. This will again diversify away twice so the value on SCR will be reduced. This is likely to have the
smallest impact of the above.

iv)

Adverse Selection is the impact associated with the underlying client base changing and not reflecting that used
in the assumption setting process

Moral hazard is the impact of fraudulent claims on the business.

Adverse selection could occur if there is a change in regulation that makes it advantageous for some low risk
policyholders to withdraw their funds from an insurance policy. The assumption setting process would have
been performed on a healthier book of business and as a result the future claims could be higher than expected
as the remaining clients are the higher risk clients. This can be mitigated through careful underwriting.

An example of Moral hazard would be a fraudulent claim. This involves a concerted effort from the client to
falsify data that would result in the payment of a benefit. For example, a client could falsify a medical note
signing them off on long term sickness and make a claim against a critical illness policy. This can be mitigated
by careful checking of processes around claims and setting clear control checks at the payment stage.

v)

If LongLife takes no action to include the genetic testing in the underwriting process this could lead to adverse
selection arising. There will be informational asymmetry between the client and LongLife at the underwriting
stage and it could lead to the policy being written with low risk ratings when in fact there is a higher
susceptibility to a serious illness that was uncovered using genetic testing. This will lead to insufficient
reserving and an increase in claims in the long term. It could also cause prospective clients to not take out CI
cover if the genetic testing highlights that they have a low risk exposure to all serious critical illnesses. This loss
in new business could impact the expense loadings within the policy. There could be liquidity issues if the
durations of the policies are shorter than expected.

vi)

If LongLife was to use the evidence of genetic testing in the underwriting stage they could reduce the rates
offered to clients. This could be seen as a benefit to those clients who have undertaken the genetic testing and
got favourable results. It may however act as a deterrent for the clients who have had unfavourable results from
the genetic testing as it would result in an increase in the rates offered and a higher premium. If LowLife sets the
genetic testing as a requirement at the underwriting stage this will either result in an increased cost, if LowLife
covers this, or a reduction in new business as LowLife becomes more expensive than the competition.

If LowLife chooses to engage with a genetic testing company, there is a counterparty risk with company. If this
company goes bust, then a new company will have to be found. This could cause additional costs. There is also
the risk that the data provided is not accurate and the client is more exposed than the genetic testing suggests,
this will create an underwriting risk.

If new business levels are lower than expected there could be a long-term expense risk as the expected income
falls whilst expenses still rise.

vii)

ERM can add value to all businesses.

The establishment of an ERM function will provide the top-down coordination necessary to make each of the
business areas work cohesively and efficiently. This removes any silos from the analysis and allows for internal
hedging.

An ERM function can prioritise each business areas risks and create an overall corporate report which is short
enough for the board to review but also has the drilldown capability required to look at the individual risks of
each area.

ERM will help to improve capital allocation within the business areas, it can help with products development,
go/no-go decisions on new projects and pricing.

ERM can lead to more predictable earnings which will increase market value, credit rating, capital requirements
and employee costs.

It allows information to travel to the correct person in a timely manner. This will allow for quick decisions to be
made to mitigate any emerging risks or react to operational risk failures.

For senior management ERM will allow them to better understand the company’s exposure to risks, understand
the links between business growth, corporate risk and return, better understand the impact of external events and
align strategy more closely with risk appetite.

ERM encourages sharing of information between business areas and allows for the links between the risks
managed by various teams.

ERM will minimise losses and the impact of any unforeseen events
ERM optimises risk mitigation strategies

The integrated framework will allow the business to react faster to any opportunities or vulnerabilities.
3

i)

Using Diagram D we can see that the equity valuation is high as it starts to flatten out. There has been a strong
growth in the equity market over the prior years but the market has levelled out and we are currently sat at the
top of the graph. After a strong investment performance there is evidence to suggest that in the next few years
there will be a downturn in the equity market. By taking a long position we can benefit from a fall in the equity
market that is expected to occur in the next few years. This can be done through a put option or some other
forward traded contract based on the current value of the equity with a sell date during the expected dip in the
equity market. This will result in the buyer purchasing an equity for more than it is worth and ActuarInvest
making a profit.

ii)

The objective of the risk manager will be top smooth the expected earnings and preserve the value of the assets.
ActuarIvnest is highly exposed to equities so a material shift in this will impact the value of the client’s
retirement fund.

The hedging strategy will allow the business to meet the guaranteed minimum value of the policy at the point of
retirement. This will protect the company from any adverse movements in the equity market. It is likely that the
structure of the option trade will be based around the selected retirement dates for the policyholder. A simplistic
approach could be undertaken to set the duration of the contract to be equivalent to the average duration, or,
there could be multiple contracts written to meet the some of the larger policies retirement dates. By removing
the risk of not meeting the guarantee the assets and liabilities can be matched and the overall risk to the business
is reduced. This protects the company from having to pay out a benefit over and above the fund value, resulting
in a lower liquidity risk and hence a lower solvency risk.

iii)

ActuarInvest will have to factor in the cost of the derivative. If this is too high the business could choose to
accept the risk at the current level and monitor the exposure. They will also have to ensure that there is sufficient
liquidity to meet any other costs associated with the contract, administration fees.

The risk that equity markets increase again. If markets rise again they could end up in a loss making position,
which could damage the fund value for the policyholder. This could cause an increased number of exits if the
returns offered are lower than expected.

They will also have to find a counterparty with which to write the contract and ensure that the credit rating of
this counterparty is sufficient to cover the contract.

The value and duration of the contract will have to be carefully selected. This includes the strike price and the
purchase prices. Careful financial modelling will have to be undertaken to find the point at which the market is
expected to return and when the cashflows are required to meet policyholder liabilities.

iv)

As the equities that ActuarInvest holds are all likely to be traded on an exchange using an equity index is likely
to be a suitable proxy for the underlying movement in the equity holding of ActuarInvest. This is more readily
available, easier to market and cheaper than a bespoke option on the specific equities that ActuarInvest. If the
position starts to move adversely it will be easier for ActuarInvest to exit their position if the option is a generic
OTC contract.

The disadvantage is that there is a mismatch between the underlying drivers of the option and the equities held
by the company. There is a change that there could be a material shift in the value of the underling equities held
by ActuarInvest without the value of the derivative changing to the same degree. This would limit the
effectiveness of the derivative as it is not accurately hedging the exposure. This could cause ActuarInvest to
have insufficient funds to meet the minimum guarantee to policyholders.

If the derivative has to be constantly rebalanced to market levels, there could be an associated administration
costs.
v)

The equity volatility could be incorporated into the model using stochastic modelling.

This can be done by adding using a suitable distribution to accommodate the expected future volatility of the
equity index. This distribution will have to include the probability and severity of the changing equity index.
This can be offset by including the option which will effectively put a floor on the value of the equities at any
time

The distribution will allow the equity volatility to change at each duration but will factor in the known
assumptions of expected times of high growth being followed by a large fall in the market. A time-series
approach is likely to be suitable to model this trend. This can be fitted using historical data, looking at any
trends that have been observed historically. This can be overlaid with expert knowledge about how future
known macro events could change the underlying equity index, this could include regulation changes or any
other economic event. This can then be back tested using historical data to validate the assumptions used in the
model.

The model can then be stress tested to change the underlying volatility assumption and analyse the materiality of
the change in driver on the result. If a small change in the assumption causes a large change in the result the
assumption will require significant testing to validate.

Subject matter experts can be consulted to check that the rates outputted from the model are reasonable and
within expectations.

Correlation matrices can be used to model the relationships between the movement in the underlying equities. It
is likely that the volatility will be specific to the underlying equity and using this as a driver would be more
suitable than using the overall portfolio volatility. The overall portfolio volatility will change as the prices and
relative weightings of the underlying equities change. The expected prices and associated volatility of the
underlying equities can be liked using a correlation matrix or by using a copula function on the underlying
equity holdings.

An external company could be contacted to purchase a volatility model which can then be incorporated into the
current model, or the development could be handled internally if there is sufficient resource and technical
expertise.

By including volatility in the ERM framework KRIs can be set against the equity index. This will give early
warnings to the Board of any adverse movements in equity markets. The KRI could be as simple as the
movement in the value of a stock exchange over a year with limits set at -5% and -10%.

vi)

The overall hedging strategy should be mostly unchanged, but it should improve if there is a model to support
the calculations

By including the equity volatility in the capital model, it will be easier to see the benefits associated with the
hedging strategy.

It will also highlight the need for a hedging strategy, as the new model will show how a change in the
underlying volatility could have a real adverse impact on the expected cost of the guarantee.

The timing and value of the derivative contracts will be easier to calculate as the model will show when the
cashflows are required. This model will have been reviewed and signed off so more confidence can be given to
the expected future cashflows. This should result in lower future cashflow and liquidity problems.

There could be more buy-in from senior management if the model shows the potential issue that will arise from
falling markets. This will make it easier to explain the results.

The impact of the hedging strategy on the expected results will be easier to explain if the model already includes
the volatility.
If the ERM framework identifies any internal hedges on equity positions it could reduce the overall exposure
and reduce the amount which is required to be hedged. This will reduce the costs associated with purchasing and
maintaining the derivative contracts.