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Chapter 2 Exercises and Solutions

Exercise 2.1
From the internet, obtain a copy of an annual report of a major financial services
provider that you are familiar with and review the comments on structure
(management and board) and what they say about their corporate governance.
Points to consider include:

does it clearly recognise the importance of sound corporate governance


to its success?
what does it say about the composition and role of the board, and its
various committees? and

does it specifically recognize the various stakeholders (e.g. shareholders,


customers, staff, the community, the environment) or is it focused solely
on shareholders?

Exercise 2.2

Consider a retail bank that accepts deposits, operates checking accounts, lends for
house purchases and business purposes, issues credit cards, etc. What liquidity risks
is such a business exposed to and how do you think it might manage such risks?
What particular aspect of its business model caused problems for the UK bank,
Northern Rock, when it found itself in financial difficulty in 2007?
Points to consider include:

the duration of the banks liabilities (deposits, cheque accounts) relative


to the duration of the banks assets (home mortgages, business loans,
credit card balances);
sources of funding other than deposits and cheque accounts e.g.
borrowing in the wholesale markets;

past and planned growth of the various product types;

ability of the bank to adapt to changing economic and market


circumstances; and

Northern Rock had grown very quickly, with a focus on mortgages.


However, the significant majority of funds to lend came not from
customer deposits but from the wholesale markets. When these markets
dried up in 2007, the banks business model no longer functioned
properly and it quickly found itself in financial difficulties.

Exercise 2.3

Do a search on the internet and find out what you can about the underlying
reasons for the 2008 global financial crisis. What types of risk were of most
consequence?
Points to consider include:

the role of banks (particularly in the US) in loosening the requirements


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for residential mortgages;

the securitisation and on-sale of mortgages;

the effectiveness of central banks and other regulators in overseeing


banking and other financial services providers, and the adequacy of
regulation;

the role of investment banks (particularly outside regulated spheres) in


creating derivatives and secondary markets based on mortgages and
other lending; and

increasing globalization, a possible herd mentality, lack of diversification,


etc.

Exercise 2.4

As an extension of Exercise 2.3 find out what is said about risk management, and
consider how consistent it is with the concept of ERM.
Points to consider include:

does it mention risk management in the context of corporate governance?


how much importance does it place on robust risk management?

does it explain that an holistic approach is taken (as per one of the
important principles of ERM)?

does it talk about risk management responsibilities for the board and
management? Is there mention of board or management committees?
and

what does it say about its risk appetite? Note: Often, little detail will be
provided about the risk appetite itself (for commercial confidentiality
reasons), but there should be mention of its importance and how the
board tackles it.

Exercise 2.5

Map each step in the AS/NZS 4360 process against the Actuarial Control Cycle. Are
they consistent?
Note in particular the feedback loops inherent in each.

Exercise 2.6

Consider an insurance company that has found that a particular feature in one of
its products is generating much higher claims than planned. However, the feature
is important from a marketing point of view, so the company doesnt want to
simply remove it from the product. Review the companys various options for
treating the risk of ongoing excessive claims.
Points to consider include:

marketing and whether it is focused on the desired markets;

training of advisers;

price, and the impact of an increase;


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initial underwriting and its impact on the quality of the risks being
insured;

claims management and its impact on the reasonableness of claims being


paid; and
limits on the amount of cover both minimum and maximum.

Exercise 2.7

Consider a bank which lends to businesses and so is exposed to significant credit


risk. Try to think of controls or other mitigating actions that might reduce both the
likelihood and impact of losses from credit risk (refer to Figure 2.2).
Points to consider include:

assessing the ability of the business to repay the loan on schedule, taking
into account the specific business and the industry in which it operates
(likelihood and impact);
allowing for the risk of default in the interest rate it charges (impact);
restricting the amount of the loan (likelihood and impact);

assignment of particular assets as security for the loan (impact); and

other controls such as restrictions on other debt the business may take on
(likelihood) and/or ensuring other debt ranks behind the banks debt for
repayment purposes (impact).