There has been a rash of interest recently among financial institutions in the use of insurance as risk-based capital. This is hardly surprising when you consider the stresses in the economy and the focus of regulators on banks, investment managers and also insurance companies to hold sufficient and available capital for the Doomsday scenario.
Many financial institutions already buy some level of insurance, but it has only recently been viewed as a potential alternative source of capital. Indeed, institutions are holding operational risk capital (under Basel II) for exposures such as fraud and “fat finger” client trading errors – such risks are generally insurable. Risk officers within firms are realizing that insurance is also a potentially material capital mitigant under the Basel II rules.
So if you are a financial institution looking to examine the upfront benefit of insurance as a component of your economic/regulatory capital for operational risk (and you have an internal capital model) – read on…
A note of caution before you do though… this is a potentially complex topic with guideline constraints from national regulators. Therefore the aim of this blog is merely to provide a few road signs. A comprehensive overview of the subject is provided in the Bank for International Settlements’ publication, “Recognising the risk-mitigating effect of insurance in operational risk modelling”.
3 Road Signs for Financial Institutions
Focusing on the practical, there are three key elements required to recognize insurance mitigation within a financial institution’s risk-based capital:
- Understand where insurance mitigates material risk events. This involves mapping the policy coverage to the firm’s capital-intensive risks, such as internal fraud. Not always a straight-forward task given the risk language of the firm is likely to be quite different to the insurance policy language. My tip is get into the risk detail and focus on certainty of insurance policy response – by which I mean really understanding the full implications of insuring clauses and policy exclusions on each individual risk exposure.
- Work with insurance underwriters to maximize the performance of the policy. Consider how the policy/ insurance process could fail e.g. late notification of a claim. Work to ensure that the policy will respond when called upon. After all, you are looking to free up capital by substituting insurance. There is plenty of guidance on this within the BIS paper mentioned earlier. Beware, insurance isn’t perfect so be prepared to determine appropriate discounts (haircuts) for the shortcoming of insurance e.g. probability of default of an insurance company.
- Value points 1 and 2 by calculating inputs for the operational risk capital model. Ideally you will be looking to produce a gross capital at risk number (at the required confidence level) as well as capital required net of insurance benefit.
The 3 Steps in Action
This works particularly well when the Operational Risk and Insurance Risk teams collaborate. The Operational Risk teams articulate the risk exposures and the Insurance Risk teams determine the nature and extent of insurance mitigation. Together they can work out the capital-like characteristics of insurance and any improvements that need to be made to the policies, applying necessary discounts (where insurance falls short of paid-up capital) with reference to regulatory guidance. Then it is over to the capital modelling team to calculate the insurance mitigation benefit.
This approach is leading to capital reductions – through the use of robust methodologies to free up capital by substituting it for insurance – as well as a framework to calculate the cost/ benefit of risk mitigation spend.
There’s Real Value in Getting it Right
So if you are an institution that already buys insurance and you have an internal model for calculating operational risk capital – now is the time to see what economic and capital benefit can be obtained by determining the extent to which insurance mitigates your risk exposures.
This is an involved process but given the increased cost and reduced availability of capital, there are potentially lucrative returns from your existing insurance policies if you get the process right.