Credit Spread

Credit spread is a measure of the difference between the yield on a risky and a risk-free security, typically a corporate bond and a government bond respectively (although other reference assets may be used, e.g. swaps). It reflects the expected cost of default, a risk premium relating to the risk of default, and a liquidity premium.

There are three common measures of credit spread. The nominal spread is simply the difference between the gross redemption yields of risky and risk-free bonds. The static spread is the addition to the risk-free rate at which discounted cash flows from a risky bond will equate to its price. The option-adjusted spread further adjusts this discount rate through the use of stochastic modelling to allow for any options embedded in the bond. [Source: Institute and Faculty of Actuaries (IFoA) Enterprise Risk Management Specialist Principles (SP9) Core Reading]

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Risk Based Capital

Risk based capital is a specific regulatory capital requirement promulgated by the National Association of Insurance Commissioners. It is a formula-derived minimum capital standard that sets the points at which a state insurance commissioner is authorized and expected to take regulatory action. [Casualty Actuarial Society (CAS) Overview of Enterprise Risk Management]

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Operational Risk

Operational risk is the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events. [Source: Society of Actuaries (SOA) Enterprise Risk Management Specialty Guide]

It is often difficult to deal with quantitatively. The potential risks cannot be modeled easily with statistical distributions, and ‘worst case’ scenarios frequently involve the insolvency of the enterprise. Increasingly, though, organisations such as banks are collecting historical data on operational risk losses which means that quantitative analysis will become more common. However, quantitative analysis will never be a substitute for the use of worst case scenarios: history tells us that it often takes just one such scenario to bring down a company. [Source: Institute and Faculty of Actuaries (IFoA) Enterprise Risk Management Specialist Principles (SP9) Core Reading]

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