SPECIMEN
COURSEWORK ASSIGNMENT
AND ANSWER
993 – (Advances in strategic risk management in
insurance)
The following is a specimen coursework assignment question and answer. It provides a
guide as to the style and format of coursework questions that will be asked and indicates the
depth and breadth of answers sought by markers. The answer given is not intended to be
the definitive answer; well reasoned alternative views will also gain good marks.
Before commencing work on an actual coursework assignment, you need to fully familiarise
yourself with the following documents:


Coursework assessment guidelines and instructions;
How to approach coursework assignments;

Explaining your results notification.
Coursework assignments involve the application of knowledge to work‐related questions.
They require you to explore issues in the workplace relevant to the unit for which you have
enrolled. The aim is that you should thereafter be able to apply this learning in the
workplace.
993 Exemplar
1
CONTENTS
Specimen Assignment .........................................................................................................3
Specimen Answer....................................................................................... ..........................5
993 Exemplar
2
993
Specimen Coursework Assignment
Coursework – assignment
Submission Rules
Before commencing work you need to fully familiarise yourself with the Coursework
assessment guidelines and instructions, including:
•
Maximum word limit for assignments (4,200 words)
•
Font type and size to be used in your assignments (Arial – size 11pt)
•
Rules relating to referencing third party work
•
Penalties for contravention of the rules relating to plagiarism and collaboration
•
Deadline for submission of coursework assignments
•
Outline of the marking criteria applied by markers to submitted assignments
Important notes
Ensure that you have:

Answered all parts of the question in sufficient depth

Answered the precise question as worded – marks will not be awarded for irrelevant
material

Correctly referenced all sources shown on the reference list in your answer

Checked your word count to ensure it is not too low as this might indicate that you are
not answering in sufficient depth and will affect the marks allocated for components in
the mark‐grid. A word count that is too high may lead to lack of focus

Reread your answer to ensure it is logically structured and that you have added value
by making sufficient conclusions and recommendations
993 Exemplar
3
993
Specimen Coursework Assignment
Specimen Assignment Question and Guidance
“…in the light of recent experience on both sides of the Atlantic, several banks whose
strategies appear to have been determined by long‐entrenched executives with little
external input to their decision‐taking appear to have fared materially worse than those
where there was opportunity for effective challenge within the boardroom.”
Source: Walker, D. (2009) A review of corporate governance in UK banks and other
financial industry entities – Final recommendations. HM Treasury.
The above statement calls into question the quality of executive level decision making in
certain organisations. Evaluate the factors that could affect the quality of executive level risk
management decisions in both theory and practice. In the light of Walker’s statement make
recommendations on how the quality of executive level decisions could be improved within
the insurance sector.
Guidance
This question covers learning outcome 2 and to a lesser extent 1 and 3. You should
consider the different factors that may affect executive level decision making and reflect on
their relevance. These factors might include:





Economic and financial imperatives (such as competition, or the cost of finance).
Stakeholder pressures (e.g. shareholders may drive short term behaviour).
Cultural factors (within the organisation and external).
Heuristics and risk perception (and the related the limits of scientific decision making
– where executives may lack the skills, experience and mental capacity to make fully
rational decisions).
Remuneration and incentives – which can drive more risk averse or risk‐taking
behaviour depending on the nature of the arrangements.
Evidence, preferably in the form of citations to appropriate academic journal articles, must
be provided to back up the arguments made.
In terms of recommendations various options could be considered, there is no simple list.
Some are outlined in the Walker review itself (and are equally relevant to insurers as they
are to banks), though there are many other relevant documents and academic articles that
could be used. Note that good students might even challenge the nature of rationality in
decision making
– what is rational? Sensible students could conclude that the focus of executives should
be on making decisions that are rational over the long term – the aim being to maximise
the value of the organisation over the longer term, rather than simple short run profit
maximisation. Recommendations might include:




Enhancing professional training, for example by requiring professional membership
of institutes like the CII.
Including more risk and decisions specialists on boards.
Reducing the amount of time executives can serve on a board.
Requiring more independent non‐executives.
993 Exemplar
4
993


Specimen Coursework Assignment
Increased disclosure requirements.
Introducing rules on compensation arrangements (already in process of course).
Exemplar Assignment Answer
1. Introduction
The principal focus of the Walker Review (2009) was on banks but many recommendations
and conclusions applied to other financial institutions such as asset managers and life
insurance companies. The focus of Walker is also more on ‘boards’ than on solely
‘executives’. The extract quoted in the Assignment instructions questions the quality of
decision making by executives and the absence of effective challenge in the boardroom.
Walker makes a distinction between the roles and needs of the chairman, non‐executive
directors, and executive board members (e.g. Finance Director, Marketing Director, Human
Resources Director and so on). Walker also makes the point that the needs of executive
board members will be different in relation to business areas outside their direct
responsibility. Walker considers the effects of the balance of power and knowledge, and the
psychological and behavioural influences that motivate decision makers at board level. The
quoted extract from Walker highlights specific problems of “long‐entrenched executives with
little external input” and a lack of “effective challenge within the boardroom”. This Answer will
respond to Walker’s recommendations but we shall argue our recommendations from a
wider base of evidence and with particular reference to leading academic theories.
2. The case of the insurance group AIG – a spectacularly bad executive decision
The importance of prudent behaviour in the financial industry was dramatically emphasised
by the Global Financial Crisis of 2007‐2008. This was essentially a banking crisis but one
major insurance group, AIG, suffered spectacular losses due to wrong decisions and is
therefore an important example for us to understand in relation to our consideration of
executive level decisions. One of AIG’s decisions was to accumulate a vast credit default
swap (CDS) portfolio of $526 billion (Sjostrum, 2009: p. 945). A credit default swap (CDS) is
a type of contract that offers protection against the non‐payment of a loan by a third party.
The protection ‘buyer’ makes fixed periodic payments to the protection ‘seller’ (the role
played by AIG) in order to get compensation. If the third party does not repay the loan
(called a credit event or default) the seller will reimburse the ‘buyer’ of the CDS. If no default
occurs, the seller of the CDS (AIG in this case) will have the payment from the buyer as their
reward for taking the risk of default (Hull, 2012: pp. 352–254). The loans that AIG
guaranteed were judged to be almost risk free but by the end of 2007 AIG covered nearly
$61 billion in securities (loans) with exposure to the so‐called ‘subprime’ mortgages.
Subprime is banking terminology for loans with poor quality security meaning a higher than
normal chance of default.
993 Exemplar
5
993
Specimen Coursework Assignment
Such loans or mortgages were part of a property ‘bubble’ that began to burst, thereby
creating losses as the value of the securities AIG was guaranteeing deteriorated. AIG hoped
the securities would regain their lost value before they would be forced to pay up. But
additionally AIG had agreed to put up money if the value of the securities deteriorated or AIG
itself became less creditworthy. AIG collapsed as a result and had to be bailed out by the US
Government. What were the AIG executives and board thinking about when they made their
fateful decisions relating to the accumulation of the CDS portfolio? This leads us to our
consideration of decision making and its influencing factors and to a well‐developed field of
academic research.
3. From Bernoulli to von Neumann & Morgenstern – early ideas about decision
making
To begin, we may briefly consider one of the earliest of the ideas proposed (by Daniel
Bernoulli in 1738) to explain how individuals make decisions under conditions of uncertainty
(i.e. ‘risky’ situations). Expected utility theory (EUT) centres on the size of a payout or gain
and the probability of its occurrence – hence its relevance to gambling and insurance. The
theory makes a distinction between a) the expected ‘benefit’ to an individual (the ‘utility’ in
the language of economics) and b) the strict mathematical expectation (or probability). The
theory helped to explain why an individual did not always make a decision based on the
most obviously rational outcome – the mathematical probability. Thus it is a useful starting
point when considering the rationality of executives’ decisions to be aware that the
complexity of decision making under conditions of uncertainty has been the subject of
debate for hundreds of years.
In the 20th Century, von Neumann and Morgenstern (2007) proposed that certain basic
axioms (assumed characteristics) had to be present to permit EUT to function as a theory for
predicting rational decisions under conditions of risk or uncertainty. The von
Neumann‐Morgenstern theory says that whenever a rational individual takes a decision he
will always chose the option that maximizes his utility as long as the following four axioms
are satisfied:
i. Completeness assumes that an individual has well‐defined preferences and can
always decide between any two alternatives. In choosing between Option A or Option B,
the individual either prefers A to B, or is indifferent between A and B, or prefers B to A.
ii. Transivity assumes that an individual also decides consistently. If there are three
Options and A is preferred to B as well as B to C, then A is always preferred to C.
iii. Independence also refers to well‐defined preferences. The starting point is to
assume that Option A is preferred to Option B. Options A and B are then mixed with a
further Option C. The Independence Axiom assumes that A is still preferred to B even
after the involvement of C.
993 Exemplar
6
993
Specimen Coursework Assignment
iv. Continuity assumes that there are three options (A, B and C) and the individual
prefers A to B and B to C. It further assumes that there should be a possible
combination of Options A and C that is equal to Option B. Putting this another way, we
could say that the individual is indifferent to choosing either the Option A + C
combination or choosing the ‘equal’ Option B.
Completely rational individuals are of course difficult to find in a real world setting. Most
decision takers are either risk averse or risk preferring so for real world cases the expected
utility theory has limited applicability. In addition, there are problems applying EUT to
companies because they are not individual people. Although EUT is highly theoretical and
therefore limited in its practical use in explaining decisions at a corporate level, it is
nonetheless an important reference point in our understanding of decision making. This
Answer now continues by considering some theoretical work that has more obvious
relevance to real world decisions.
4. Using mathematical formulae and models to aid decision making
One approach that is widely used in the financial sector, though still subject to some
controversy, is the approach referred to as the ‘capital asset pricing model’ (CAPM):
In this model a company’s equity cost of capital
equals the risk free rate of return
plus
an individual risk premium
It explains shareholders’ demand for risk‐adjusted
compensations. Without any risk in the world the shareholders’ compensation for supplying
the company with funds would be equal
. Of course there is always risk. Therefore the
risk premium
measures the company’s exposure to risk. In this risk premium
there are two components, and
. is also referred to as the ‘beta’ factor and
explains the relationship between the movements of the asset return (usually share price
returns)and the market‐wide portfolio’s return. It answers the question: How much does a
company’s asset return change if the market portfolio’s return alters by 1%.The higher
the , the higher is the individual risk of a company (called idiosyncratic risk). It can be
assumed that a rational investor holds not just one company share in his portfolio, but
several companies. In this case the idiosyncratic risk decreases due to this diversification.
Furthermore, there is a systematic risk factor . Contrary to , represents the risk that
affects all companies at once (through macroeconomic factors). The second part of the
risk premium
represents the excess return of the market portfolio over the
risk‐free rate of return (Hull, 2012: pp. 8 – 9). Of course, there are assumptions to be
satisfied in order to apply the CAPM.
993 Exemplar
7
993
Specimen Coursework Assignment
Table 1: The assumptions of the CAPM
(Adapted from Hull, 2012, pp. 10 – 11)
Assumption
1
Rationality of investors
2
Independent residuals
3
Only one investment period
4
Lending and Borrowing at
5
No taxes
6
Homogenous expectations
(the risk free rate of return)
The assumptions are unrealistic. (1) It has been shown that investors are more likely to be
risk averse or risk preferring than risk neutral. (2) The residuals (systematic risks) are not
independent, especially in the same industries (e.g. insurance industry). (3) The investment
periods of different investors are heterogeneous and not just one period for all investors. (4)
All investors can borrow at the risk‐free rate of return, which would imply the absence of risk.
As mentioned above, risk is as a multidimensional construct and affects every business.
Therefore the lender always demands compensation for the risk exposure. (5) Assumption
five can easily be disproved, because there is no country in the world without taxes. (6) It is
also unrealistic to assume that all investors have homogenous expectations regarding asset
returns.
Despite the unrealistic requirements, the CAPM relationship holds true for many situations.
In financial service companies the CAPM is used for firm valuations and for insurance
pricing models. The essential question is whether the return of the insurance company
compensates for the (underwriting) risks (Ligon and Cather, 1997: p.1001; Hull, 2012: p.13).
Applying the CAPM to another example it becomes clear how another risk factor,
stakeholder pressure, affects risk decision taking. The higher the risk associated with a
company investment, the higher is investors’ demand for return. Therefore stock‐listed
insurance companies will monitor risk exposures closely in order to keep the equity (and
debt) cost of capital as low as possible (Koller, Goedhart and Wessels, 2005: p.300 and
318). The CAPM may not be a perfect theory but it has proven to be a useful measure of risk
to aid investment decisions by highlighting the appropriate rate of investment return for
different levels of risk.
993 Exemplar
8
993
Specimen Coursework Assignment
5. Cultural factors
Another factor that affects risk management decisions is ‘culture’. There is no common
standard of culture, but for this Assignment Question the following definition is helpful: “… a
set of shared representations used by a group to think and act.” (Specht, Chevreau and
Denis‐Remis, 2006: p.525). Researchers have published several papers relating to the
influence of culture on the decisions of individuals and groups. The work of Douglas and of
Hofstede is of particular importance.
Douglas (2007) explains cultural differences with two scales in her ‘grid and group cultures’.
The horizontal scale measures how much the culture/group controls the individuals. The
vertical scale measures how much control by the group the individuals accept. By combining
the two dimensions, four quadrants emerge (Figure 1).
Figure 1: Group and Grid Cultures (Douglas, 2007, p.2)
Isolate
Positional
Individualist
Enclave
The Isolate quadrant represents individuals who are not (or very weakly) influenced to act
by a specific group. The acceptance of control is relatively strong. People classifying for the
“isolate” quadrant are usually prisoners, very poor people or even strictly supervised
servants. Their life is characterised by a vast amount of structures or constraints (Douglas,
2007: p. 6).
The Positional quadrant explains cultures in which people belongs to a group and are
heavily influenced by it. All roles within it are allocated and behaviour is determined by rules.
Larger groups consist of several smaller groups, implementing a hierarchical state. An
example is the traditional Japanese family where the determinants of family life are arranged
by gender, age and timing (Douglas, 2007: p.4).
Individualistic cultures have a relatively weak form of ‘group and grid’ control. In such an
environment every individual is just concerned with his or her own wellbeing. In the absence
of wealth and power, this culture could be defined as egalitarian. But as soon the community
993 Exemplar
9
993
Specimen Coursework Assignment
drifts to wealth and power the culture fails to realise the egalitarian aims (Douglas, 2007:
p.6).
The enclave culture is characterised by a relatively high group control. Moreover, there are
almost no hierarchical structures between members. This group of people differentiates itself
from other groups – an example being sects. Sect leaders’ aims are often focused on
preventing their members from leaving the group. Hence they malign all other groups
outside the sect (Douglas, 2007: p.5).
In her further work, Douglas researched the relationship between risk and culture. She
pointed out that risks play a critical role in distinguishing cultures from each other (Tansey
and O’Riordan, 1999: pp.74 ‐75). Although Douglas’ theory provides a comprehensive
insight in the cultural setting of and within groups, there are some disadvantages – one
being that her cultural theory does not give any information on the psychological aspects of
cultures (Gross and Rayner, 1985: p.18). Also, the theory neglects dynamic effects and
changes and is unable to distinguish between social systems (Tansey and O’Riordan, 1999:
p.82).
Several other models exist. For example, Janis’ (1972) ideas on the psychological
phenomenon of ‘groupthink’ that can occur within groups, where the desire for harmony and
or conformity in the group can result in potentially very irrational and destructive
decision‐making outcomes. Groupthink was identified as a problem in many organisational
failures, including within some of the banks that were badly affected by the recent financial
crisis (e.g. HBOS and RBS). Arguably this is very much part of a cultural problem and
Hofstede introduced five dimensions to characterise cultures.
Table 2 Hofstede’s cultural dimensions
(Soares, Farhangmehr and Shoham, 2007, pp.280 – 281)
Dimension
1
Individualism – collectivism
2
Uncertainty avoidance
3
Power distance
4
Masculinity – femininity
5
Long-term orientation
993 Exemplar
10
993
Specimen Coursework Assignment
The first dimension uses a similar approach to that of Douglas. In individualistic cultures,
individuals only care for themselves or their closest family. This is contrary to that in
societies characterised by collectivism where everybody belongs to a group that looks after
their members and their families. Hofstede, like Douglas, uses uncertainty avoidance (risk
aversion) to describe and distinguish cultural groups. The equality/inequality of cultures is
considered in Hofstede’s third dimension, power distance and masculinity/ femininity of
cultures is measured in his fourth dimension. The values in more masculine countries are
achievement and success, whereas the values in more feminine countries are caring for
each other and life quality. The last dimension, long‐term orientation, represents the
orientation towards future benefits and situations. On the other hand there are short‐term
oriented cultures, in which their members only care about rewards in the near future. In the
literature, Hofstede’s dimensions are discussed as a “simple, practical, and usable” solution
to describe cultural differences (Soares, Farhangmehr and Shoham, 2007: p.238). The
possibility of applying cross‐country comparisons is one of the major advantages of
Hofstede’s dimensions. On the other hand, Hofstede’s fifth dimension, long‐term
orientation, is not widely accepted (Fang, 2003: p.354).
The cultural setting was one critical factor in the emerging financial crisis. In the years
between 2001 and 2006 a risk accepting collectivism evolved. Almost every market
participant thought that the housing boom would never end (Gorton, 2009: p. 31). For a
rational individual this might seem odd, but if everybody in a society/community, even the
government, thinks the house price boom would last forever, why would anyone resist
earning money from risky investments? This phenomenon is also called herding (Ashby,
2010: p.26). We have a severe case of herding and collectivism in the insurance
industry ‐AIG was willing to take tremendous amounts of risk without recognising the
hazardous situation in their business model. This condition is widely supported by Anastasia
Kelly: “All of AIG's top managers, though, had grown up under Hank Greenberg, and like
most people, they weren't thrilled about changing things. I wanted to put in a worldwide
compliance and regulatory organisation, but I kept hearing, why do we need this?” (Loomis,
2010). Obviously such a culture encourages an aversion to change.
6. Heuristics and risk perceptions
Another influence on the decision making by managers is the usage and application of
heuristics and risk perceptions. One critical factor in risk management is the gathering and
assessment of relevant data. In the financial services industry this is frequently done with the
help of computers in order to safeguard 100% accuracy and reliability. But sometimes these
processes take a huge amount of time and individuals tend to apply their own
decision‐taking shortcuts in their head. They look for relevant memories and assess them
internally. Of course these memories are not 100% complete. Instead of assessing the risk
situation in a statistically correct way, the individuals apply certain best practice methods that
worked out in the past, also known as heuristics. But there are situations in which these
993 Exemplar
11
993
Specimen Coursework Assignment
concepts (heuristics) are not rational (Hubbard, 2009: pp.97 – 98). One famous heuristic is
the ‘peak end rule’ published and proved by Kahnemann (1999, p.4). In the conceptual
framework the assessment of a situation is widely based on the strongest (the peak) and the
last (the end) experience. The concept is best described with an example. In a study people
were asked to hold their hands in water in two different stages. In the first stage the hands of
the people lasted 60 seconds in water at 14°. In the second stage the hands lasted in water
at 14° but for 30 additional seconds. In this additional 30 seconds the temperature was
increased step by step. After the experiment the participants were asked which stage they
would chose to be repeated. Surprisingly the majority chose the second stage, although the
pain/risk lasted 30 seconds longer. Obviously the participants assessed the risk/situation
based on the peak (after 60 seconds) and on the end (the increasing temperature). This is a
kind of averaging in which the individual choses the higher mean temperature (stage 2)
(Jørgensen, 2010: p.508).
In this special case the peak end rule leads to unreliable and unrealistic outcomes. Though
there are also situations in which the peak end rule is reliable (Cojuharenco and Ryvkin,
2008: p.333). In addition to the peak end rule there are several best practice style heuristics
that examine proposals for problem solving. These heuristics might be very useful for
insurance companies for the assessment of risks underwriting risks. One contribution of this
kind is the paper by Allan (2006), which focuses on the risk assessment of bird strikes at
airports. Another work is that of Madachy (1997). Yeo et al. (2001, p.49) showed that a data
driven assessment process provided a more reliable prediction of claims costs in the car
insurance sector than the heuristics approach of Samson and Thomas (1987). Using
heuristics to calculate insurance premiums could cause prediction errors and therefore
produce premiums that were too high or too low.
7. Remuneration‐related factors
Another factor that drives risk management decisions is the remuneration of personnel who
are in charge of risk‐taking decisions. Chorafas (2009) points out that the bonus system,
which was first implemented in the 1990s, became a pay‐for‐poor‐performance system over
the years. Managers were paid a vast amount of money for no apparent improvement.
Therefore preposterous bonus payments created a vicious risk‐taking attitude (Chorafas,
2009: p.195). There are more aspects to the issue of poor compensation structures than
greed and corruption. This is especially the case for financial institutions which interact in an
increasingly complex environment. Ashby (2009, p.9) showed that it is rather the structure of
the compensation than the bonus’ volume that matters in terms of risk taking. Hence the
people interviewed in the study described the following flaws in remuneration systems:

The incentives led to a short‐term and sales driven attitude in the financial industry.
993 Exemplar
12
993


Specimen Coursework Assignment
The risk decisions had no down side risk for the managers, as there were no
negative consequences regarding their salary. Therefore managers could therefore
chose amongst risky and less risky alternatives without any fear of losses.
The regulatory framework had severe flaws. There were simply no incentives for the
managers to implement an effective risk management system.
These issues created a business environment best described as moral hazard (Ashby,
2010: p.22). Another contribution links the risk‐taking decisions back to the state of the
economy. Raviv and Sisli‐Ciamarra, (2013, p.66) write “Understanding how similar pay
packages may yield different risk levels under different economic conditions is crucial to
designing compensation packages…”. The link between the level of compensation for
publicly held insurance companies and the return on assets (ROE) was investigated. It
appears that executives in stock exchange listed insurers chose more effectively between
investment alternatives than did privately owned insurers. An explanation for this condition is
that large shareholders monitor executives’ decisions closely in order to adjust the
remuneration to an accounting based measure like the ROE (Ke, Petroni and Safieddine,
1999: pp.206 ‐207).
8. Enterprise Risk Management
Enterprise Risk Management (ERM) may not be the answer to sound decision-making in
the face of risk. Indeed, it may be part of the problem. The publication of influential reports
and widespread adoption of risk and governance standards have combined to make ERM
an established part of corporate governance and strategic decision-making. There is an
assumption that it has been proven to work.
Mikes and Kaplan (2015, p29), however, argue that risk management approaches are
largely unproven and still emerging. They have identified the existence of an ‘ERM mix’. In
some organisations it is embedded in “the formal planning and resource allocation process
and also influences key strategic decisions”. In others, the ERM focus is on compliance and
internal controls or merely as independent facilitator.
Further, ERM literature tends to assume that strategic decisions largely occur in the
strategic planning process. But in the strategic management literature, the role of formal
strategic planning has been diminished by an emerging view that most strategic decisions
occur outside the formal process. According to Bromiley (2014, p9), “if strategy scholars are
correct, then the ERM emphasis on risk analysis in formal strategic planning is misguided”.
9. Recommendations on how to improve the quality of executive decisions
As the most important decisions are taken by the board of directors of a company, this part
of the Answer provides recommendations on how to improve the structure and composition
993 Exemplar
13
993
Specimen Coursework Assignment
of the board. Generally there are two different kinds of board structures, the ‘two‐tier’ board
and the ‘unitary’ board. Both are subject to controversial discussions. The two‐tier board is
obligatory for stock exchange listed companies in Germany (e.g. Allianz Group) and is also
used in many other European and Asian countries. One feature of this structure is that there
are two boards rather than merely one. There is the regular management board, which is
similar to the Anglo‐American counterpart and a supervisory board. While the management
board represents and rules the company, the supervisory board controls and advises the
management board to avoid bad consequences. As the shareholders and the
employees/trade unions are entitled to elect their representatives, there are two kinds of
members in the supervisory board. The composition is dependent on the number of
employees (Allianz, 2012: p.175).
Unlike the two‐tier structure, unitary boards (such as at AIG) are characterised by having
only one board of managers being in charge of two kinds of tasks. Usually a unitary board is
in charge of implementing policies, appointing senior executives, selecting officers and
monitoring managers to avoid bad management decisions. As there are no legal regulations
regarding the board, the structure of the board is widely dependent on a set of firm‐specific
circumstances. Whilst the number of board members is legally determined, the
shareholders elect the directors at their annual meeting for a one‐year period (AIG, 2013:
p.30).
In recent years, several publications have contributed to an improvement of decision‐taking
processes in boards. The Walker report points out that out of date and uninformed
management opinions led to negative outcomes (Walker, 2009: p.37). Walker’s report
(2009) identifies certain approaches to improve the decision‐taking process. The first and
probably the most important improvement would be to implement a working risk culture
(Walker, 2009: p.92). A risk culture is generally defined as a culture “that enables and
rewards individuals and groups for taking the right risks in an informed manner.” (The
Institute of Risk Management, 2012: p.6). There are many features that characterise an
effective risk culture, but for the purpose of this Answer, information flow is probably the
most important. Effective risk cultures encourage a constant information flow up and down
the hierarchical layers of the corporation – including negative news (Institute of Risk
Management, 2012: p.6). In other words, the board and all other employees should aspire
to a state of shared responsibility for risks (Kirkpatrick, 2008: p.12). Whilst a bad or failed
risk culture may be easily recognised post-disaster, there is now a view that a unique ‘good
risk culture’ does not exist (Power, Ashby and Palermo, 2014). This may not, however, rule
out the possibility of useful preventative action by boards. Implementing a risk culture
requires the board to understand its present state of risk culture first before it can ask the
question, ‘how to achieve an effective risk culture?’ Finally, the board should make
proposals for implementation of a plan to change the culture (The Institute of Risk
Management, 2012: p.9).
993 Exemplar
14
993
Specimen Coursework Assignment
As mentioned earlier, Walker (2009) concluded that the attitudes of executives are often
entrenched. Therefore the first step, to understand the risk cultural setting, is probably the
most challenging. How can an executive (on the board) change something if they live with
an attitude of that they are already doing everything in the right way? This question may best
be answered by substituting the heuristical behaviour of the board with significant risk
monitoring through an internal control system. Further, Eisenberg (1997, p.264) links the
internal control to the board in order to make the decision making function meaningful. In
order to understand the present risk culture, generating a snapshot of the risk situation of a
company is essential. Simons (1999, pp.86 – 92) introduced a scoring model, also known as
the risk exposure calculator (See Figure 2 below).
Figure 2: The risk exposure calculator
(Simons, 1999, p.87)
In this model framework, three kinds of risks are considered: growth, culture and information
management. These categories consist of three risks each, forming nine relevant exposures
overall. After the assessment of the nine risks, the scores are added together to generate an
overall score. This score gives significant information on the state of a company’s risk
culture. By the means of a scale, three major states can be distinguished: The safety, the
caution and the danger zones. Especially in the light of Walker’s statement, this calculator
is meaningful because "executive resistance to bad news” is included. An insurance
company board executive with a resistance to advice would therefore score a rather high
value.
993 Exemplar
15
993
Specimen Coursework Assignment
The culture scoring aims of Simons (above) have appeal but are possibly difficult to apply in
practice. Other ideas for aligning risk culture with good decision making continue to emerge.
For example, an understanding of the trade-offs organisations face when attempting to
‘manage’ their risk cultures (e.g. balancing risk support for disciplined business decisions
against the risks of imposing excessive controls, or balancing ethics and incentives as levers
over behavioural change) could enable the “formulation of prescriptions, in the form of
simple questions for practicing managers and staff, which may be more useful and targeted”
(Power, Ashby and Palermo, 2013: p.34).
There are other ways of improving the decision‐taking processes of boards of insurance
companies. One approach is the inclusion of independent decision takers in the
decision‐taking process. While executive directors are directly affiliated with the company,
non‐executive directors are not employed in the company and therefore independent. As
most of the board members vote in line with the CEO, independent non‐executive members
should be more able to vote against the CEO (Schwartz‐Ziv and Weisbach, 2013: p.363).
Another approach would be to either propose training through independent professionals or
to invite risk professionals on to the board. Walker (2009, p.46) strongly recommends
business awareness sessions ‐especially for non‐executive directors. This can ensure a
meaningful contribution to decisions from the non‐executive directors. As mentioned earlier,
remuneration also plays a critical role in improving the decision‐taking processes.
Risk‐taking behaviours should be rewarded in an appropriate way, while excessive risk
taking/overly risk aversion should be avoided (Institute of Risk Management, 2012: p.15).
Walker (2009, p.105) also points out that the risk disclosure is a critical topic. Regulatory
frameworks like Basel II/III (for banks) and Solvency II (for insurance companies) oblige
institutions to disclose information on risk management. The extent to which this happens
depends on the legal framework of the relevant country (Hull, 2012: pp.278 – 279). Walker,
however, proposes the disclosure of information regarding key risk exposures, the risk
appetite and tolerance as well as the dynamic assessment of the risk appetite. Generally,
risk appetite is defined as:
“The amount of risk, on a broad level, an entity is willing to accept in pursuit of
value. It reflects the entity’s risk management philosophy, and in turn influences the
entity’s culture and operating style. … Risk appetite guides resource allocation. …
Risk appetite [assists the organization] in aligning the organisation, people, and
processes in [designing the] infrastructure necessary to effectively respond to and
monitor risks.” (Rittenberg and Martens, 2012: p.3)
This definition shows the multidimensional characteristic of risk management (Haimes, 2009:
pp.1647 and 1651). Risk appetite plays a critical role in risk management since it
determines major parts of a company’s strategy. For that reason, risk appetite requires clear
993 Exemplar
16
993
Specimen Coursework Assignment
definitions, communication and a monitoring process (Rittenberg and Martens, 2012: p. 1).
Monitoring ensures the required match between the company’s strategy and the risk
appetite. If there are deviations, the risk appetite needs to be readjusted (KPMG, 2008, p.7).
In addition to many others, one part of risk appetite is the risk tolerance – the setting of
tolerance ranges for risk exposures. This approach is often used to monitor and compare the
actual risk exposure with the defined risk appetite (KPMG, 2008: p.8). As Walker (2009, p.
105) implied, boards should focus on the definition of risk appetite and tolerance in order to
ensure meaningful and flawless decisions.
10. Conclusion
The Introduction to this Answer concluded that Expected Utility Theory is an unrealistic tool
for examining real world decisions in the insurance industry. In reality there is a wide range
of factors that influence the executive‐level decision-taking process. This concentration of
factors has created a highly complex environment for insurance companies (and others) to
cope with. Thus executive level decision takers are in a need of workable techniques to
achieve more effective and prudent decisions. Some simple approaches exist, such as the
board composition, and there are more sophisticated methods like the implementation of a
working risk culture. Either way, the factors influencing decisions grow more complex and
fast‐paced. Therefore it must be an obligation for every executive decision taker and for
decision researchers to develop new and detailed methods that will improve the adequacy of
business decisions taken under conditions of risk and uncertainty.
993 Exemplar
17
993
Specimen Coursework Assignment
References
AIG (2013). 2012 Annual Report. AIG.
Allianz Group (2012). Annual report 2011 – Risk Report. Allianz Group, pp. 149 – 179.
Ashby, S. (2009). Picking up the Pieces – Risk Management in a Post Crisis World –
Recommendations for Financial Institutions and their Regulators.Nottingham Financial
Services Research Forum.
Ashby, S. (2010). The 2007‐09 Financial Crisis: Learning the Risk Management Lessons.
Nottingham Financial Services Research Forum, Paper 65.
Allan, J. (2006). A Heuristic Risk Assessment Technique for Birdstrike Management at
Airports. Risk Analysis, 26(3), pp. 723 – 729.
Bromiley, P., McShane, M., Nair, A., Rustambekov, E. (2014) Enterprise Risk Management: Review,
Critique, and Research Directions, Long Range Planning, http://dx.doi.org/10.1016/j.lrp.2014.07.005
[Accessed 10th September, 2015]
Chorafas, D.N. (2009). Financial Boom and Gloom – The Credit and Banking Crisis of
2007‐2009 and Beyond. New York (NYC): Palgrave Macmillan.
Cojuharenco, I., Ryvkin, D. (2008). Peak End rule versus average utility: How utility
aggregation affects evaluations of experiences. Journal of Mathematical Psychology,
52, pp. 326 – 335.
Douglas, M. (2007). A history of grid and group cultural theory. University of Toronto.
Eisenberg, M.A. (1997). The Board of Directors and Internal Control. Cardozo Law Review,
19(2), pp. 237‐264.
Fang, T. (2003). A Critique of Hofstede’s Fifth National Culture Dimension. International
Journal of Cross Cultural Management, 3(3), pp. 347 – 368.
Gorton, G. (2009). The Subprime Panic. European Financial Management, 15(1), pp. 10‐46
Gross, J.L., Rayner, S. (1985). Measuring culture: A paradigm for the analysis of social
organization. New York (NYC): Columbia University Press.
Haimes, Y.Y. (2009). On the Complex Definition of Risk: A Systems‐Based Approach.
Risk Analysis. 29(12).
Hubbard, D.W. (2009). The Failure of Risk Management ‐Why it's Broken and How to Fix it.
Hoboken (NJ): John Wiley & Sons.
Hull, J.C. (2012). Risk Management and Financial Institutions. 3. Edition. Hoboken (NJ):
993 Exemplar
18
993
Specimen Coursework Assignment
John Wiley & Sons.
Institute of Risk Management (2012). Risk culture – Under the Microscope Guidance for
Boards. The Institute of Risk Management.
Janis, I. L. (1972). Victims of Groupthink: a Psychological Study of Foreign‐Policy
Decisions and Fiascoes. Boston: Houghton Mifflin.
Jørgensen, M. (2010). Identification of more risks can lead to increased over‐optimism of
and overconfidence in software development effort estimates. Information and Software
Technology, 52, pp. 506 – 516.
Kahneman, D. (1999). Experienced Utility and Objective Happiness: A Moment‐Based
Approach. In: Kahneman, D., Tversky, A. (1999). Choices, Values and Frames. New York
(NYC): Cambridge University Press and the Russell Sage Foundation. Ch. 37.
Ke, B., Petroni, K., Safieddine, A. (1999). Ownership concentration and sensitivity of
executive pay to accounting performance measures: Evidence from publicly and
privately‐held insurance companies. Journal of Accounting and Economics, 28, pp. 185 –
209.
Kirkpatrick, G. (2008). The Corporate Governance Lessons from the Financial Crisis.
OECD Financial Market Trends.
Koller, T., Goedhart, M., Wessels, D. (2005). Valuation – Measuring and Managing the
th
Value of Companies. 4 ed. Hoboken (NJ): John Wiley & Sons.
KPMG (2008). Understanding and articulating risk appetite. KPMG Australia.
Ligon, J.A., Cather, D.A. (1997). The informational value of insurance purchases:
Evidence from the property‐liability insurance market. Journal of Banking & Finance, 21,
pp. 989 – 1016.
Loomis, C. (2010). Inside the crisis at AIG. CNN Money [online] (Last updated on 18
February 2010) Available at
<http://money.cnn.com/2010/02/17/news/companies/aig_bailout_kelly.fortune/>[Accessed
12 December 2013].
Madachy, R.J. (1997). Heuristic Risk Assessment Using Cost Factors. IEEE Software,
May/June, pp. 51
– 59.
Mikes, A. and Kaplan, R. (2015) When One Size Doesn't Fit All: Evolving Directions in the Research
and Practice of Enterprise Risk Management, Journal of Applied Corporate Finance, Volume 27
Number 1. pp. 1-12.
993 Exemplar
19
993
Specimen Coursework Assignment
Power, M., Ashby, S., and Palermo, T. (2013) Risk Culture in Financial Organisations, London School
of Economics and Plymouth University. Available at
http://www.lse.ac.uk/researchandexpertise/units/carr/pdf/final-risk-culture-report.pdf [Accessed 27
September 2014]
Raviv, A., Sisli‐Ciamarra, E. (2013). Executive compensation, risk taking and the state of the
economy. Journal of Financial Stability, 9, pp. 55‐68.
Rittenberg, L., Martens, F. (2012). Understanding and Communicating Risk Appetite.
Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Samson, D., Thomas, H. (1987). Linear models as aids in insurance decision making: the
estimation of automobile insurance claims. Journal of Business Research. 15, pp. 247 –
256.
Schwartz‐Ziv, M., Weisbach, M.S. (2013). What do boards really do? Evidence from
minutes of board meetings. Journal of Financial Economics, 108 (2013), pp. 349 – 366.
Simons, R. (1999). How Risky is Your Company?. Harvard Business Review, May‐June
1999, pp. 85‐94.
Sjostrum, Jr., W.K. (2009). The AIG Bailout. Washington and Lee Law
Review, 66(3), pp. 943 ‐991.
Specht, M., Chevreau, F.R., Denis‐Remis, C. (2006). Dedicating Management to Cultural
Processes: Toward a Human Risk Management System. Journal of Risk Research, 9(5), pp.
525 – 542.
Soares, A.M., Farhangmehr, M., Shoham, A. (2007). Hofstede's dimensions of culture in
international marketing studies. Journal of Business Research, 60, pp. 277 – 284.
Tansey, J., O’Riordan, T. (1999). Cultural theory and risk: a review. Health, Risk & Society,
1(1), pp. 71 –90.
von Neumann, J., and Morgenstern, O. (2007). Theory of Games and Economic
Behaviour. 60th anniversary edition. Princeton (NJ): Princeton University Press.
Walker, D. (2009). A review of corporate governance in UK banks and other financial
industry entities
– Final recommendations. HM Treasury.
Yeo, A.C., Smith, K.A., Willis, R.J., Brooks, M. (2001). Clustering Technique for Risk
Classification and Prediction of Claim Costs in the Automobile Insurance Industry.
International Journal of Intelligent Systems in Accounting, Finance & Management. 10, pp.
39 – 50.
993 Exemplar
20