ACTEX Learning Flashcards Learning & Memorizing Key Topics and Formulas

Investment Risk Management

Spring 2019 Edition

Richard E. Owens, FSA, MAAA, CFA Copyright © 2019, ACTEX Learning, a division of SRBooks Inc.

No portion may be reproduced or transmitted in any part or by any means without the permission of the publisher.

ISBN 978-1-63588-696-2

Printed in the United States of America. GOVERNANCE

Set 1 of 3

Topic 1: Governance SOA Learning Objectives

ACTEX Learning QFII – Set 1 Card 3 “The Candidate will be able to: 1. Compare the interests of key stakeholders. 2. Explain principal versus agent conflict. 3. Identify sources of unethical conduct and explain the role of a fiduciary. 4. Describe governance mechanisms that attempt to address these conflicts. 5. Understand the importance of an organization’s culture in effectuating governance. 6. Explain how governance may be structured to gain competitive advantages and efficiencies. 7. Demonstrate understanding of how ethics relates to business decision- making, and relate ethics in business to personal ethics.”

Source: SOA Learning Objectives and Learning Outcomes

ACTEX Learning QFII – Set 1 Card 4 What are the Major Categories of Risk Facing Businesses Today?

ACTEX Learning QFII – Set 1 Card 5 1. Market and Economic Risk - Risk from exposure to capital markets 2. Interest-rate risk - Risk from unanticipated changes in interest rates 3. Foreign-exchange risk - Risk of fluctuations in currency exchange rates 4. Credit risk - Only default risk, spread risk is covered by market risk 5. Liquidity risk – Risk of forced liquidation of assets in a short time frame or at a steep discount 6. Systemic risk - Risk of failure of a financial system 7. Demographic risk – Risk of changes in demographic elements such as mortality, longevity, lapse, policyholder behavior, etc. 8. Non-life insurance risk – Risk of fluctuation in frequency or severity of claims in casualty insurance 9. Operational risks – Generally, risks arising from failures of people, processes or systems or arising from natural disasters – see separate flash card for the common sub-categories 10. Residual Risk - Risks remaining once any action has been taken to mitigate them Source: Financial Enterprise Risk Management, Ch 1

ACTEX Learning QFII – Set 1 Card 6 What Are the Major Categories of Operational Risk?

ACTEX Learning QFII – Set 1 Card 7 1. Business continuity risk - Risk that an external event will disrupt ability to do business as usual 2. Regulatory risk – Impact of legislative or regulatory changes 3. Crime risk – Risk of dishonest behavior, including theft, fraud, arson, hacking or moral hazard 4. People risk – Generally risk arising from non-criminal actions of people 5. Bias – Deliberate or subconscious miss-assessment of risks or expected outcomes 6. Legal risk - Poorly drafted legal documents or exposure to litigation 7. Process risk – Failure or inefficiency of a business process 8. Model risk – Flawed, inaccurate or inappropriate models 9. Data risk – Inaccurate or corrupted data used in models 10. Reputational risk – Loss of confidence on the part of one or more constituencies of the organization 11. Strategic risk – Risk of inappropriate or ineffective strategy (or the lack of strategy) Source: Financial Enterprise Risk Management, Ch 1

ACTEX Learning QFII – Set 1 Card 8 What are the Common Features of an ERM Framework?

ACTEX Learning QFII – Set 1 Card 9 1. Assessment of the context including the internal and external environment of the organization and the interests of its stakeholders. 2. Consistent risk taxonomy (classification system) 3. Identification of risks – both quantifiable and not quantifiable 4. Determination of target levels of risk 5. Comparison of actual levels of risk to targets 6. Decision on how to handle risks beyond the targets 7. Implementation

Source: Financial Enterprise Risk Management, Ch 1

ACTEX Learning QFII – Set 1 Card 10 What are the Elements of Good Corporate Governance from an ERM Perspective?

ACTEX Learning QFII – Set 1 Card 11 A. Board constitution 1. Split the roles of chairman and chief executive 2. Majority of directors should be non-executives 3. Majority should be independents – especially the audit, compensation and executive committees B. Board education and performance 1. Board members need generic skills to hold executives accountable 2. Training, continuing education and performance appraisal of board members is essential C. Board compensation 1. Linked to individual performance of the director and performance of the company overall D. Board transparency 1. Includes open sharing of information to the extent possible, including board minutes Source: Financial Enterprise Risk Management, Ch 1

ACTEX Learning QFII – Set 1 Card 12

What are the Learning Objectives for Chapter 1, Introduction: The Case for Investment Ethics?

ACTEX Learning QFII – Set 1 Card 13 “After reading this chapter, students should be able to: “Describe some of the significant scandals in the history of investments.

“Explain the history and basic function of financial regulatory agencies.

“Identify key SEC filings and forms.

“Discuss the features of the investment industry that create opportunities for unethical professionals.

“List and discuss the four fundamental principles of investment ethics.

“Recognize and understand the importance of developing an ethical consciousness.”

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 14 History of scandals: 1792 Duer and the Six Percent Club

ACTEX Learning QFII – Set 1 Card 15 Club purchased shares to drive up prices, create other investor interest driving prices high, then club dumped shares

Decline in economy and over leverage caused scheme to “fall apart”

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 16 History of scandals: 2008 financial crisis

ACTEX Learning QFII – Set 1 Card 17 “Generally agreed” a bubble in housing prices, low interest rates, initially low default rate, subprime borrowing, overconfidence, heavy borrowing

2007 default rates increase, value of MBS securities declines rapidly

Bear Sterns collapse partially due to overleverage

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 18 History of scandals: Bernard Madoff 2008

ACTEX Learning QFII – Set 1 Card 19 10-year + Ponzi scheme, defrauded investors of over $65 billion

Investment advisory firm that provided client “consistent, high returns, and against all odds seemingly continued to do so for many years.”

Declining markets in 2008, withdrawals were in excess of new funds

Madoff realizing scheme would be exposed, turned himself in to the authorities

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 20 History of scandals: Charles Ponzi 1920

ACTEX Learning QFII – Set 1 Card 21 Saw arbitrage opportunity, coupon costing one cent in Spain could be redeemed for six cent stamp in US

Promised investors 50% return in 45 days

Demand for the arbitrage outstripped supply

Ponzi paid older investors with new investors money, keeping good amount for himself

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 22 History of scandals: Sampling of Financial Scandals

ACTEX Learning QFII – Set 1 Card 23 Mike Milken – 1980s insider trading

Nick Leeson – 1995 rogue trader from Barings Bank

Enron – 2001 fraudulent accounting to inflate profit, hide debt, inflating the stock price

WorldCom – 2002 accounting fraud to inflate profit

Jerome Kerviel – 2007 rogue trader of Societe Generale

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 24 Why are ethical principles specific to the investment industry needed?

ACTEX Learning QFII – Set 1 Card 25

Scandals helped bring about the collapse of the financial markets in 2008

Many could have been avoided if appropriate questions had been asked about certain behaviors

Scandals do provide insight to help create ethical safeguards

Book a practical guide

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 26 Definition: Mortgage-backed securities

ACTEX Learning QFII – Set 1 Card 27 “securities created from a portfolio or pool of mortgages; investor receives income from the securities from the interest and principal repayments on the underlying mortgages.”

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 28 Definition: Ponzi scheme

ACTEX Learning QFII – Set 1 Card 29 “a fraudulent scheme whereby old investors’ returns are paid out of funds raised by new investors”. Also known as a “pyramid scheme”. Named after Charles Ponzi, a 1920’s originator of the fraud

Source: Investment Ethics, Chapter 1

ACTEX Learning QFII – Set 1 Card 30