Jeffrey S. Grange

Wendy Dowd

English

Research Papers in Economics

Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Objectives
• Discuss role of insurance in operational risk
management.
• Provide overview of insurance market for
operational risks.
• Outline reasons for including insurance in the
New Basel Capital Accord.
• Offer recommendations for how to incorporate
insurance in the New Basel Capital Accord.
Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Jeffrey GrangeCapital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Insurance of Operational Risk
and the
 New Basel Capital AccordCapital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Presentation Outline
• Role of insurance in risk management
framework.
• Overview of Insurance Market for Operational
Risks
• Insurance and the New Basel Capital AccordCapital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Identification
Assessment/
Measurement
Mitigation/
Management Monitoring
Reporting
Operational Risk Management Framework
Risk Transfer - Insurance
Framework adopted from “Operational Risk Regulatory Approach Discussion Paper”, ISDA, September 2000Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Risk Transfer
Exchange unknown financial impact of specified
events to a third party for a known financial cost.
•  Insurance
•  Securitization
•  OtherCapital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Risk Mitigation/Management Objectives
Reduce Probability of Event
             (Frequency)
Reduce Economic Impact of Event
                    (Severity) Objective
Strategies Internal Controls
Recovery/Continuity Planning
Internal Controls
Risk Transfer (Insurance)Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Importance of Risk Identification
Sources of risk:
• Internal control weaknesses or lack of
compliance (controllable)
• External and other (non-controllable)
Risk Transfer is critical tool
for managing exposure to
non-controllable sources of risk.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Importance of Risk Measurement
• Necessary to measure and evaluate impact of
various risk transfer strategies.
• Critical to cost-benefit analysis of risk transfer
decisions (coverages, deductibles, limits, etc.)Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Insurance as Risk Management Tool
Direct Benefits Indirect Benefits
- Reduces financial impact of loss. - Loss control and risk management services
   provided by insurers.
- External monitoring and investigation of
  risks by insurance company.
- The cost and availability of insurance acts as
   incentive to reduce losses.
- Causes awareness of the risks, must make
  decisions about what to retain and what to
  transfer.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Underlying Gross Risk
Implement Controls and procedures
to reduce and frequency and severity.
Residual Risk
RISK IDENTIFICATION
RISK MEASUREMENT
Implement Risk Transfer to reduce
severity.
Net Risk ALLOCATE CAPITAL
RISK MITIGATION STRATEGIESCapital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Insurance Market for Operational Risks
• Traditional insurance products
• Alternative risk transfer products
• Customized products
• Future productsCapital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Traditional Insurance Products
• Peril-specific.
• Stable, well-developed market.
• Widely available.
• Well known and understood.
• Collectively cover the scope of operational risk,
(but not individually).
• Insurance industry well capitalized.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
New Product Development
• Single multi-peril basket product
• Umbrella to compliment existing broader cover
at a higher attachment point
• Alternative risk transfer and tailored products
New products evolve as banks needs and risks
evolve.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Insurance under the New Accord
January 2001, Basel Committee on Banking Supervision, “Consultative Document on
Operational Risk”
Specifically, insurance could be used to externalise the
risk of potentially “low frequency, high severity” losses,
such as errors and omissions (including processing errors),
physical loss of securities, and fraud.  The Committee
agrees that, in principal, such mitigation should be reflected
in the capital requirements for operational risk.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Insurance under the New Accord
Updates in September 2001, Working Paper:
• Reduced overall level of the operational risk capital
charge partly to recognize the risk-mitigating effects of
insurance.
• If explicit recognition of “robust and comprehensive
insurance” is permitted, it should be limited to AMA.
• There should be a limit on the overall impact of
insurance risk mitigation on the final capital amount.
September 2001, Basel Committee on Banking Supervision, “Working Paper on the
Regulatory Treatment of  Operational Risk”Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Insurance and Pillar 1
“Insurance is an effective tool for
mitigating operational risks by reducing the
economic impact of operational losses, and
therefore should have explicit recognition
within the capital framework of the new
Basel Capital Accord to appropriately
reflect the risk profile of institutions and
encourage prudent and sound risk
management.”
   Pillar 1
Minimum
Capital
Requirements
November 2001, “Insurance of Operational Risk under the New Basel Capital Accord”,
a working paper submitted by Insurance Companies.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Regulatory Capital
Regulatory capital treatment of operational risk
should:
– recognize differences in quality of risk management
and degree of risk transfer.
– encourage sound risk management within firms by
clearly setting out benefits to be gained from
actively managing and improving the quality of
their controls and prudent use of risk transfer.
– Evolve as risk transfer market evolves.Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Capital Treatment for Insurance
• Should recognize traditional insurance products as
well as more comprehensive alternative forms of risk
transfer.
• Should be explicit recognition of insurance under each
of the continuum of approaches.
• Residual risks of insurance should be appropriately
accounted for within the capital treatment (e.g. breadth
of coverage, timing of payments, conditions and
exclusions).Capital Allocation for Operational Risk Conference    Boston, September 14-16. 2001                                                       Wendy Dowd
Capital Treatment for Insurance
• Should recognize the portion of risk transfer in the
unexpected loss layer.
• Should have a limit to amount of relief.

Insurance of operational risk and the New Basel Capital Accord

http://www.bostonfed.org/bankinfo/conevent/oprisk/dowd.pdf

Insurance of operational risk and the New Basel Capital Accord

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