A call to action for Op Risk insurers

Insurance companies must not waste time now the Basel II regulators have shown an amber light to operational risk insurance, say Roland Avery and Daniel Butler.

The world’s insurance industry has only three months in which to show global banking regulators in detail how operational risk insurance can play a role in reducing the op risk capital charges proposed under the Basel II capital accord.

The regulators, previously wary of the idea, told insurers in July that they might recognise a role for insurance for banks using advanced approaches to calculating the amount of capital they will need to set aside under Basel II to guard against the risk of loss from such operational hazards as fraud, technology failure and trade settlement errors. For the first time, regulators, in the shape of the Basel Committee on Banking Supervision, will require capital charges specifically against operational risk.

Recognition of a role for insurance in advanced approaches, which allow banks to use their own risk models based on internal operational loss data, would be subject both to certain criteria and an overall limit on the reduction of capital held by the banks.

The regulators decided to consider insurance following their late-June decision to delay the coming into force of Basel II from 2004 to 2005. This postponement was in response to mounting concern in the world’s banking industry about many aspects of the accord and the tightness of the Basel II schedule.

The regulators’ new stance on insurance represents considerable progress since January, when they issued their second consultative paper on the Basel II accord, which will determine what proportion of their assets large international banks will have to set aside as a protection against banking risks from 2005. Basel II is intended to be a more risk-sensitive set of capital adequacy rules than the one-size-fits-all regime of Basel I, the current accord that dates from 1988 and which over 100 countries have adopted.

In their January consultative paper, the regulators said they accepted the principle that insurance might be used to reduce op risk capital charges, but added that in practice they had many reservations. They were worried on three main counts: that insurance payouts would prove too slow to save a bank in an emergency; that exclusion clauses would limit the effectiveness of the policies; and that in using insurance, banks might be swapping operational risk for credit risk - namely the chance of the insurer itself going out of business.

The shift on insurance reflects the work undertaken by the industry in the first six months of this year in demonstrating a possible role for insurance in the op risk capital charge - albeit on a conceptual basis - to the Basel regulators in a coordinated manner.

But it is clear the real work of convincing the banking supervisors is only just starting. And the work must be completed by the end of November at the latest, so that the supervisors will have time to review it and publish their response in the third Basel II consultative paper that is expected to be issued early in the new year. The Basel Committee intends to publish its final version of Basel II by the end of 2002.

It is now up to the insurance industry to work on the development of criteria for the recognition of op risk insurance. The industry will also argue for insurance to be recognised in the two less complex Basel II approaches to calculating op risk capital charges, as well as the advanced approaches. While elements of this work have already been carried out, there are three key areas the insurance industry needs to focus its resources on and develop responses to.

1. Definition and taxonomy of banks’ op risk exposures
This needs to be resolved as a priority. The definition and categorisation of operational risk should be positive, specific and measurable. The industry needs to examine the categorisation proposed by the Committee and propose necessary amendments.

2. Data collection and validity
The insurance industry possesses a significant amount of op risk loss and claims data. The task is to set up the methodology to collect, pool and disseminate the data in a manner acceptable to the rules of the banking and insurance industry.

3. Scope of risk transfer/risk financing solutions.
The insurance industry will need to outline not only the advantages and limitations of current insurance products, but also their potential to meet regulatory requirements, including the effect of, and qualifying criteria for, mono-line policies (such as bankers blanket bond, electronic and computer crime, professional indemnity and property all risks), multi-line insurance (such as blended programmes and umbrella policies covering broad-form fraud cover and legal liability), comprehensive op risk contracts, and the effect of combining risk transfer and risk financing. It will explore the possibility of suitable dispute resolution structures.

Each area will need to be tackled by working groups drawn from the insurance industry.

Many in the insurance industry recognise the scope of the challenges faced, as is evidenced by the commitments made in responses to the second Basel II consultative paper by such bodies as the Property and Casualty Insurance Industry Working Group and the Basel Accord Insurance Working Group. The responses were published in full by the Basel Committee on the Bank for International Settlements’ website (www.bis.org) and summarised in Operational Risk’s June and July editions.

The challenges are significant but not insurmountable, and many industry participants, including ourselves at Aon, are committed to providing the expertise and resources to achieve the collective goal.

This is good news for banks and regulators, since if the working parties are successful in achieving their goal of providing a framework by which insurance can reduce the operational risk capital charge of banks, the sensitivity of the capital charge will be enhanced.

This is achieved by rewarding banks that, as part of a prudent risk management strategy, try to mitigate their operational risks through properly structured insurance and risk transfer mechanisms. The insurance market provides additional incentives by rewarding banks that have proven op risk management methodologies and better loss records, by providing broader cover and more competitive premiums.

However, there is considerable concern among banks and in the insurance industry that the Basel supervisors appear uninterested in allowing banks using the two less complex approaches to calculating op risk capital charges under Basel II to obtain capital relief through insurance.

The concern is particularly acute because only a handful of banks are likely to qualify for the wider choice of more sophisticated advanced approaches that the regulators are considering now that the accord has been delayed a year.

The advanced methods are likely to include the internal measurement approach originally proposed by the Basel Committee in its consultative paper as well as a so-called loss-distribution approach, and possibly methods based on qualitative adjustments using scorecards and extreme value theory.

In line with Basel II’s risk-sensitive intentions, the more complex the approach used by a bank, the less will be its op risk capital charge.

Standardised approach
But initially most banks will probably use either the basic indicator or standardised approaches. The basic indicator approach, which is the least complex, is likely to take the simple form of a charge based on a bank’s gross revenue. Under the standardised approach, banks are divided into business lines which are assigned risk indicators on which the charge is based.

Once the qualifying criteria for insurance under the advanced approaches has been agreed, imagine a scenario where Bank X, for example, qualifies for the standardised approach and Bank Y for an advanced approach. They both buy identical risk transfer insurance policies, but Bank Y receives capital relief for the insurance it purchases and Bank X does not. Is the mitigating impact of the insurance policy any less for Bank X than for Bank Y?

One explanation given for this is that the regulators are not comfortable about insurance being built into the framework of the basic indicator and standardised approaches.

While it is clear that it is more straightforward to apply insurance to internal measurement and loss distribution approaches, it is now up to the insurance industry to provide a robust framework to demonstrate the applicability of insurance across all approaches.

The clock is ticking, but the insurance industry is rising to the challenge.

Roland Avery is managing director of the financial institutions and professional risks division of insurance broker Aon. Daniel Butler is a director of the same division.Operational Risk