FRM Part 1 | Test ID – 0004 | Questions - 30

1. Which of the following is not a major risk faced by a bank in a post–financial crisis world?

A.Investment banking is a risk because in many circumstances the bank is putting its own capital at risk;
this is typically never enough risk to put the bank out of business, but it is a risk.
B.Deposit insurance
C.Capital adequacy
D.Agent‐based securities trading

2. Large institutions have to calculate two levels of capital: economic and regulatory. Which of the
following pairs the definition of each type of capital with its relative magnitude to the other type?

A.Economic capital is the capital the bank has committed to either private lending or investment
banking activities. Effectively, this is the capital the return on equity (ROE) of the bank will be based on
and is often less than regulatory capital.
B.Regulatory capital is the capital banking regulators believe the bank needs to keep in reserve to avoid
losses that would put the bank's survival at risk. The amount of regulatory capital is often calculated to
be much less than the economic capital.
C.Economic capital is an internally determined amount of capital a bank has determined it needs to keep
in reserve to avoid losses that put the survival of the bank at risk. Economic capital is usually more than
regulatory capital because the bank has more information about its activities than regulators do.
D.Regulatory capital is the amount of capital regulators determine is necessary to keep the chance of a
bank failure very low. Regulatory capital is almost always more than economic capital, but banks have
no choice but to keep capital levels above regulatory capital requirements.

3. The question of moral hazard and deposit insurance is often discussed with respect to a liquidity crisis
or runs on a bank. In this case, providers of short‐term liquidity, who are very risk averse, pull funding
from a bank. Should the market rely on a lender of last resort (LOLR), like a central bank, or deposit
insurance in crises and how does that create moral hazard?

A.If an LOLR takes collateral for loans provided to the borrower, the LOLR faces the risk that those
credit assets could default and damage the LOLR.
B.The availability of deposit insurance may change an institution's views on risk and ignore liquidity or
funding risks in its risk planning.
C.Deposit insurance increases the cost of funding a bank's balance sheet because providers of that
capital will demand more credit spreads if the depositor insurance has to be paid out.
D.Moral hazard is created when the banks continue to lend and create capital, knowing the LOLR
would likely bail out the providers of short‐term liquidity that are unable to fulfill their obligations.
4. The investment banking process is the way private equity, equity in a business held by a small number
of investors, is sold to the public. The most common way this occurs is through an initial public offering
(IPO), but there are other ways private investors can sell their stock publicly. Which of the following
investment banking financing arrangements is correctly paired with its definition and/or potential risks?

A.Best efforts—This type of investment bank financing means the bank will use its bankers to market
the deal and will use bank capital to hold any remaining unsold equity.
B.Dutch auction—This approach means the bidder for the highest number of shares, the investor willing
to buy the largest block of shares, will set the price for the rest of the investors, but auction participants
have the option to refuse to participate in the auction once that price is announced if the investor
believes the price is too high.
C.Private placement—This type of investment bank financing is where a bank, for a fee, will take a
previously issued IPO back from the public and place it with a few large institutional investors.
D.Firm commitment—This type of financing activity is when a bank will agree to use firm capital to
underwrite (purchase) from the issuer (the previously privately held company) should the public IPO
not be a successful as hoped.

5. In modern banking, there are many relationships that may overlap. For example, a bank may have a
commercial banking relationship that consists of lending to fund operations with a client but also may
have an investment banking relationship that includes selling equity to the public. This has the potential to
create conflicts within the bank if information among each separate group is not handled properly. Which
of the following correctly describes a potential conflict and a potential solution to a conflict of interest?

A.If a retail investor asks a bank for advice on securities to purchase, the banker may be tempted to
recommend securities the banker knows the bank has in inventory and wishes to sell. The Glass‐Steagall
Act of 1933 prevents this conflict by requiring the advisor to disclose that the bank owns the securities it
is recommending.
B.A commercial bank has made a corporate loan to an existing customer. Through a review of the
company's books, the commercial bank is uncomfortable with the credit risk and wants the investment
bank to underwrite a bond that can be used to repay the loan. There is effectively no way to stop this
conflict of interest.
C.An investment banker goes to a large, privately held company to discuss potential financing options
for an initial public offering (IPO). The investment banker returns from the meeting and meets with the
research team covering that sector to discuss the possibility of a “buy” rating if the investment bank
helps with the IPO. The 1999 Financial Services Modernization Act would prevent this conflict by
putting a wall between research and investment banking.
D.A private company has approached an investment bank about an acquisition of a competitor it knows
to be failing, but the market has not accounted for these non‐public problems in the price yet. The
privately held company wants to make a below‐market offer for the competitor in an effort to force
disclosure of the problems and the investment bank takes this information to the trading desk to sell all
holdings of the target company. The 1987 Federal Reserve Board rule change that allowed bank‐holding
companies to have investment banking and commercial banking interests as long as there was no
communication between the two would prevent this conflict.
6. Modern banks, commercial and investment banks, have two sides of the business generally referred to
as a “banking book” or a “trading book.” What is the distinction among the two?

A.The distinction is a regulatory distinction between assets held to maturity and assets marked to market
on a daily basis.
B.The distinction is primarily an accounting distinction, with the trading book holding the marked‐to‐
market assets and the banking books mostly holding loan and commercial banking assets that don't have
a marked‐to‐market value.
C.The banking book holds hard‐to‐value assets that are considered “marked to model” for accounting
and bank capital purposes.
D.The banking book is made of assets held aside for potential losses on loans to corporations or
individuals.

7. Part of the problem during the financial crisis was a movement away from lending to customers in the
traditional retail banking sense to a business model that originated loans simply to distribute them. How
did this lead to problems during the financial crisis?

A.Banks weren't equipped to originate and service as many loans as Wall Street needed to securitize.
B.The securitization of loans is an off‐balance‐sheet activity that enables an undisclosed increase in
leverage.
C.Lending standards decrease when banks know they will not hold the risk of the loans they make.
D.The distribution of loans spread the subprime credit risk to a wider number of investors that might
otherwise not be exposed to the risk.

8. Which of the following is not a property or feature of the insurance type listed?

A.Whole life insurance—This is sometimes called permanent insurance. The insurance accrues value
during the time when the insured makes payments, called the accrued life value, and when payments by
the insured stop, that value is the maximum guaranteed payout at death.
B.Term life insurance—This differs from whole life because it is insurance for a specific term, although
one type of term life insurance is guaranteed to renew year after year even in the event of a major health
event, like a stroke, but at a different rate.
C.Variable life insurance—This type of life insurance benefit varies by how much the insured can pay
in any given year and if no payments are made, the coverage is retained at the previous year's maximum
benefit amount.
D.Endowment life insurance—This type pays out at the end of the term even if the insured has not died
but the beneficiary must be a trust (endowment) that is set up for the beneficiaries of the insured.
9. A state regulator is reviewing the financials for a property and casualty insurance. This company
earned $25 million in premiums and made $12 million in insurance payouts. The expenses for this
company, including loss adjustments and selling expenses, were $5 million. Of the premiums received,
the company earned $3 million on investments.

What is the loss ratio, expense ratio, combined ratio, and operating ratio, in that order, for this company?

A.48%, 20%, 68%, 56%

B.20%, 56%, 48%, 68%
C.75%, 56%, 20%, 48%
D.112%, 47%, 20%, 48%

10. GARP considers the two most significant risks to face insurance companies to be adverse selection
and moral hazard. Which of the following correctly describes the moral hazard or adverse selection it is
paired with and, if a solution is proposed, which is also paired with the correct way to overcome the
problem?

A.Adverse selection is the concept that offering the same price of insurance to everyone will attract
more high‐risk cases because there is no cost penalty associated with being a bad driver or in poor
health. Unfortunately, there is never a way to completely overcome the problem of adverse selection.
B.A central bank introduces a deposit insurance plan and this causes higher‐risk depositors to adversely
select banks with the highest insurance coverage in case their own businesses default on loans with the
bank.
C.The only way to completely overcome adverse selection is to know as much as possible about the
insurance risk prior to underwriting the policy. Not only does this eliminate adverse selection but it
reduces moral hazard for the insurance company as well, because they know the insurance company is
on the hook for the risk they underwrite.
D.A new hire at a company opts into the most premium health coverage possible and pays extra for
coverage for their family too. This premium offering, even though at a higher price, will adversely
select employees or family members with prior existing conditions and tend to lead to more health care
demands.

11. Just like banks, life insurance companies and property‐casualty companies have to set aside capital to
sustain their business. Unlike banks, this is regulated at the state level and not the federal level. Which of
the following is true about the capital requirements for either a life insurance company or a property and
casualty company?

A.Property‐casualty companies maintain reserves equal to an actuarially determined present‐value

current potential payout, and this number is usually overly conservative.
B.On the balance sheet of a property‐casualty company, you will find the equity is much higher than on
a life insurance company because the events are far less predictable.
 C.Since the duration of the liabilities is much longer for a life insurance company, the balance sheet
must remain liquid to make potentially large life insurance payouts and maintains a much larger equity
position in the balance sheet.
D.Banks can lose depositors and value investments, so banks have risks to both sides of the balance
sheet, whereas life insurance companies don't have a risk to the liability side of the balance sheet
because if customers stop paying premiums, those policies lapse and that capital reserve can be returned
to retained earnings.

12. How does financial guarantee, capital requirements, or regulation differ between insurance companies
and banks in the United States or the EU?

A.Unlike the United States, insurance companies are centrally regulated and have remained largely
unchanged since the 1970s with the same rule applying to all EU member states. The original rule
system, Solvency I, implied that with a capital base of 10%, life insurance companies have a 95%
chance of survival.
B.In the United States, banks are regulated at the state level and insurance companies have a central,
federal regulator. However, state insurance regulators can set capital requirements higher than the
federally set minimum capital requirement.
C.In the EU, insurance companies are centrally regulated, but in the United States, they are decentrally
regulated. Furthermore, while each state in the United States can set its own capital requirements, the
EU is working on Solvency II that assigns capital based on a wider range of risks than Solvency I.
D.In the United States, when a life insurance company goes insolvent, its policies are often taken over
by other insurance companies and there is a guaranty fund that is partially paid by the Federal Deposit
Insurance Corporation to protect those insurance companies that take over the failed company's policies.

13. There are two general types of pension plans: defined benefit and defined contribution. What are the
general differences between the two and what risks are associated with each for either the plan
administrator or plan investor?

A.Defined benefit plans are promises made by employers based on long periods of employment, are
paid for by the employer, and are considered a benefit to the employee. However, a key risk may be that
the defined benefit plan falls short of the capital needed to actually pay the employee benefits.
B.Defined contribution plans allow employees to pool a defined investment for their own benefit but the
plan (employer or pension plan manager) makes investment decisions for the entire pool.
C.Defined benefit plans have the feature of allowing employees to set their own desired benefit at
retirement and then contribute the amount the fund manager agrees to accept for that defined benefit at
retirement. It is basically an employee‐sponsored annuity.
D.Defined contribution plans will allow employees the capacity to contribute to an individual account
that will be managed by the pension fund manager, but if the employee leaves the company they can
take that investment with them, typically in the form of a rollover IRA.
14. Why are hedge funds and mutual funds so different?

A.Mutual funds are “long‐only” vehicles and cannot short or hedge stocks.
B.Hedge funds are heavily regulated and require investors to be accredited investors or institutions.
C.Hedge funds and mutual funds are similar in that they disclose net asset value (NAV) daily, but hedge
funds may “mark to model” assets, which are difficult to value in their NAV, whereas mutual funds
cannot.
D.A mutual fund must disclose an investment policy that guides the investment decisions or asset
allocations, and while a hedge fund may provide guidance on investment decisions, it is not bound to
those disclosures.

15. In contrast to mutual fund performance, which is often disclosed over a number of years, hedge fund
performance is much more difficult to estimate. Which of the following correctly describes why
performance is difficult to track and correctly defines a measurement bias and a performance
measurement bias?

A.Regulators require hedge funds registered with the SEC to report returns, but this omits smaller funds
that don't require SEC registration and creates a selection bias where only the performance of the largest
funds are reported.
B.Most of the performance returns are voluntary and those funds that perform poorly or shut down
either don't report or remain in the sample size without performance data.
C.When reporting returns and a new fund does not yet have at least five years of performance data,
funds often report how their trading strategy would have performed but do not include the return net of
fees, which inflates historic returns.
D.Since hedge funds' returns are typically greater than mutual funds, and large hedge funds are required
to disclose their holdings, large funds tend not to self‐report performance to avoid mutual funds'
replicating their strategy.

16. Which one of the following statements regarding traditional whole life insurance is incorrect?

A. The beneficiary receives the sum assured only on the death of the insured

B. The payout time is known with certainty

C. The insured pays premium throughout their life

D. Premiums payable may increase with age

17. Under term life insurance, the sum assured is payable only if:

A. The insured dies within the specified time period

B. The beneficiary is alive at the end of the specified term

C. The insured lives beyond the specified term period

D. The beneficiary dies within the specified term period

18. Mike Dean, FRM, enters into a contract with an insurance company where he pays a lump sum of
$40,000 upfront, in exchange for regular yearly payments, each amounting to $2500, for the next 25
years. This is most likely:

A. A term life insurance contract

B. An annuity contract

C. A universal life contract

D. An Endowment life insurance contract

19. A noncontributory group life insurance contract is a policy where:

A. Premium payments are made only in the first year, without further payments in later years

B. Premium payments are shared by the employer and the employee

C. The employer pays the premium in full, without financial input from employees

D. The insured company and its employees are offered free life insurance, in exchange for free goods and
services

20. The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one Survival Life

years year probability expectancy

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

Calculate the probability of a man dying between his 30th and 31st birthday.

A. 0.97372
B. 0.001234
C. 0.001419
D. 0.00138
21. The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one Survival Life

years year probability expectancy

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

Calculate the probability of a man who is aged 30 dying in the second year?

A. 0.002435
B. 0.001443
C. 0.001419
D. 0.001445

22.The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one Survival Life

years year probability expectancy

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

Assuming that:

I. Interest rate = 4%
II. Premiums are paid annually in advance (at the beginning of the year)
III. Compounding is semi-annual

A 30-year-old man takes up a term insurance policy that expires in two years.

Calculate the expected payout given that the policy has a sum assured of $100,000.
 A. 144.62
B. 275.09
C. 283.42
D. 125

23. The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one Survival Life

years year probability expectancy

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

Assuming that:

I. Interest rate = 4%
II. Premiums are paid annually in advance (at the beginning of the year)
III. Compounding is semi-annual

If the policy has a sum assured of $100,000, and a 30-year-old man takes up a term insurance policy that
expires in two years, then which of the following is closest to the break-even premium payable by the
policyholder?

A. 140.37
B. 123.62
C. 150
D. 80

24. How does increase in longevity risk affect the profitability of lifelong annuity contracts?

A. It increases profits made by the insurer

B. It decreases the profits made by the insurer

C. It reduces the return on investment to the policyholder

D. It has no effect on profitability

25. How does increased mortality risk affect the profitability of life insurance contracts?

A. It increases profits made by the insurer

B. It decreases the profits made by the insurer

C. It reduces the return on investment to the policyholder

D. It has no effect on profitability

26. Which of the following strategies presents the best way to deal with longevity and mortality risks in
the insurance business?

A. Adding a substantial risk premium to the final break-even premium payable

B. Avoiding high-risk business

C. Reinsurance

D. Using a high interest rate

27.

Richard Brad, FRM, owns a high-rise mixed-use building located in the heart of London. Although he has
complied with all quality and safety standards, he fears that a major accident, such as a fire, might result
to injuries to residents and third parties and he might be forced to pay for such damages. To protect his
building and avoid losses resulting from large-scale compensations, Mr. Brad could most likely:

A. Make life insurance and disability insurance mandatory requirements for every tenant as well as
visitors

B. Reinsure the building against large-scale loss

C. Seek property insurance

D. Seek property-casualty insurance

28. Which of the following is a good example of moral hazards under property insurance?

A. Faking of death

B. Legal suits filed by third parties for losses incurred the moment they realize that the party at fault is
insured

C. A tendency to leave a car unlocked after successfully insuring it against theft

D. A bank taking fewer risks after benefiting from government-sponsored deposit insurance
29. If an insurance company offers the same premium to both smokers and non-smokers, it is likely to
attract high-risk policyholders and might contend with more payouts than initially expected. This problem
is called:

A. Moral hazard

B. Poor selection

C. Adverse selection

D. Adverse risk modeling

30. The main difference between a defined benefit scheme and a defined contribution scheme is that:

A. While defined benefit schemes are employer-sponsored, defined contribution schemes are run by
employees with little/no input from employers

B. Defined contribution schemes last for a maximum of 40 work-years while there’s no time limit for
defined benefit schemes

C. Defined benefit schemes are tax deductible but defined contribution schemes are not

D. A defined benefit scheme promises a specific income whereas, with a defined contribution scheme, the
income depends on factors such as the size of monthly contributions and investment performance