UK opposed to allowing wider op risk insurance role in European capital rules

UK regulators are opposed to the wider use of operational risk insurance to reduce capital charges under complex new European Union (EU) safety rules for banks and investment firms, regulatory sources said.

Earlier this week the European Commission said it would consider the use of insurance to reduce capital charges against operational risk under all three op risk approaches, from the simplest to the most complex, in rules it wants to bring into force in late 2006. The commission’s insurance proposal is broader than that contained in the Basel II treatment of operational risks such as fraud, technology failure, legal risk and trade settlement errors.

The Basel Committee on Banking Supervision is prepared to look at insurance as a way of reducing protective capital only in the context of advanced op risk approaches based on mathematical modelling and operational loss databases.

Regulators with the UK's Financial Services Authority (FSA) support the Basel II position on op risk insurance. The FSA added that advanced approaches quantify a firm’s op risk exposure, and thus in turn make a discount on capital charges for insurance something feasible and measurable.

But the FSA will continue to argue to fellow regulators in Britain’s EU partner states that there is no sensible way of using insurance to offset op risk capital charges in the two simpler approaches – the basic indicator and standardised approaches.

Under these simpler approaches, the op risk capital charge is calculated as a percentage of a firm’s gross income. Gross income is a crude and not very sensitive measure of the operational risk, regulators said. UK regulators doubt they could ever be persuaded there’s a feasible way of allowing a discount for insurance on capital charges arrived at via the basic and standardised approaches.

Both Basel and European regulators stress they have still to be persuaded by the insurance and banking industries that op risk insurance will work in practice. Regulators want be sure that op risk assurance will result in prompt payment of claims unhindered by exclusion clauses, and that it will not simply change a bank’s operational risk into a credit risk – namely the risk that a bank’s insurer might fail. If they don’t get that assurance, op risk insurance will be off the agenda for all approaches.

The FSA sees the answer lying in lower rates of op risk capital charges for investment firms than for banks under the basic and standardised approaches – something the European Commission also proposed earlier this week. This would reflect investment firms’ generally lower exposure to large, unexpected losses from operational risks. It would also reflect the fact that the failure of an investment firm is unlikely to be a threat to the safety of the financial system as a whole in the way a bank failure often is.