MITIGATING OPERATIONAL RISK EXPOSURE: RISK TRANSFER SOLUTIONS

Mitigating Operational Risk Exposure: Risk Transfer Solutions ABA OPERATIONAL RISK MANAGEMENT FORUM April 17th 2008

Michel Rochette, MBA, FSA ENTERPRISE RISK ADVISORY, LLC

Topics • Context and recent developments • Opportunities to go beyond Basel II compliance • Op risk mitigation environment: – Self mitigation – Self insurance – Risk transfer: • Insurance mitigation • Alternative risk transfer: Captives • Capital markets solutions • Case: Insurance mitigation optimization

Context:

“Regulators are becoming concerned that banks

may seek to manage the [Operational Risk Capital] charge rather than to manage the risk itself�

Susan Schmidt Bies, Federal Reserve Board Governor New York, March 29, 2006

Reminder: Sound Practices Paper-BIS 2003 • Development of an appropriate op risk mgt environment: – Board level & management with clearly defined roles.

• Risk Management: – Identification – Assessment – Mitigation & monitoring – All material activities, products, processes and systems covered – Monitor operational risk profile – Policies/processes/procedures to manage the risk – Must chose appropriate risk mitigation strategies in light of their risk appetite.

Operational Risk: ERM View Basel II

Strategic

Attracting & retaining talent Competition Managing organizational change M&A/business diversification New product strategy New market strategy Outsourcing and supplier chain Governance of risk Interest rates Credit environment Liquidity FX environment Equity environment

Financial

Financial liabilities

Internal processes Operational System failure Internal/External Fraud Risks Employment practices: Health & Safety / Loss of Key People Clients/products/Business practices External incident Legal impact included Insurance allowed as mitigant Brand/Reputation Corporate social responsibility Production volumes/pricing impact Loss of Intellectual property Other risk mitigation integrated

Business

US Regulators’ Expectations: AMA • Risk-Based Capital Standards.

– – – –

Applies to IRB and AMA only at this time.

Banks with $250 billion US+ in consolidated assets. –Core – Other banks may adopt this new framework: - Opt–in Standardized approach for general banks will be finalized in Q12008 with qualifying criteria.

• Compliance and op risk must be analyzed together: – Definition of loss is consistent with Basel II including legal losses.

– Legal loss: litigation, settlements, fines resulting from failure to comply with laws, regulations, prudent ethical standards, contractual obligations in any aspect of the bank’s business.

– May also explain industry interest to implement GRC/ERM.

US Regulatory Criteria for Other Mitigant • Regulators are open to other risk mitigant approaches if: – FI must calculate its operational risk exposure.

– Mitigant must be able to absorb losses with sufficient certainty.

– Must receive prior written approval.

• Mitigant must cover potential operational losses in a manner consistent with holding regulatory capital.

• Regulators will consider other risk mitigant in due course on “ the basis of growing experience”.

– Insurance industry has that experience.

– Not necessary to reinvent the wheel.

– European regulators are taking a fresh analysis of op risk mitigant.

Operational Risk Mitigant Environment

Yearly Profit/Internal Controls

Expected

Purely Self Insurance/ Insurance/ART

Unexpected

Insurance/ Capital Mkts

Catastrophic

Benefits of Integrating Operational Risk Mitigant • Business perspective: – Your institution is NOT in the business of managing op risk. → Low TOLERANCE for this risk.

– Insurance is in the business of managing op risk. → APPETITE for op risk.

– These businesses are complementary, should work together and be more integrated internally.

– This trend is observed more and more.

• Regulatory perspective: – “Agencies will take into account whether a particular operational risk mitigant covers potential operational losses in a manner equivalent to regulatory capital”.

– Mitigant would cover insurance and other approaches subject to certain minimum qualifying criteria.

Universe of Op. Risk Mitigation: Characteristics • Internal management: controls – Implemented without much consideration of the costs involved.

– Embedded in the AMA calculations through control effectiveness scores.

• Self insurance: – Calculating and allocating regulatory capital for op risk is a form of self insurance by banks.

– “Insurance” is direct if calculated by AMA. – “Insurance” is indirect if embedded in the regulatory credit capital as traditionally done by banks in the general regulatory rules.

• Insurance: – – – – –

Always existed.

Private and public solutions.

Not integrated very often with operational risk groups.

Standard policies don’t always match.

Optimization of the insurance buying decision in relation to the operational risk exposure is not usually done.

Universe of Op. Risk Mitigation: Characteristics • Alternative Risk Transfers (ART): – Used by companies to mitigate risks that the traditional insurance markets cannot cover.

– Probably already used by some of your institutions without your knowledge!

– Covers services like Captives for op risks like workers comp and external events.

• Capital markets solution: – In existence for some op risks, mostly external events.

– Some op risks are securitized like CAT Bonds.

– Cover both risk transfer and risk finance solutions.

– More talk in the industry about op risk derivatives.

Operational Risk Mitigant Environment

Insurance

Expected

Unexpected

Catastrophic

US Op Risk Requirements vs. Insurance • Definition of op risk loss: – All expenses associated with a loss event except: • Opportunity loss • Foregone revenues • Costs to enhance/correct/prevent future op. risk events.

• No prescribed methodology: – Most banks use LDA.

• Op. Risk Capital is like selfinsuring the risk.

• Insurance is to indemnify: – Regulatory definition of loss is similar to insurance definition of loss.

• Insurers pricing methods: – ALL use LDA – EOL = Deductible – UOL = What insurers usually pay.

• Insurance is contingent capital to your bank.

US Regulatory Limitations of Insurance • Risk Based Capital Relief of insuring some op risk exposure, MAXIMUM of: – Op. Risk Exposure adjusted for qualifying op risk mitigant minus offsets (if, any) – 80% * (op risk exposure – offset ).

• Implications: – If your institution is an AMA, regulatory relief of integrating mitigant is limited but not the business benefit.

– If your institution is not AMA, better managing op risk will reduce your “indirect” op risk capital that is embedded in the credit capital through a better management of the premiums/costs of your traditional insurance overages.

Operational Risk Mitigant Environment

Insurance/ Capital Mkts

Expected

Unexpected

Catastrophic

Capital Markets Solutions- Overview Type

Insurance

Risk transfer: Securitization/ ILS/Exotic Ins Structures/Op Risk Derivative

Contingent Capital (CAT Bond for liquidity)

Credit Quality

Varies by counterparty

Collaterisation

Varies by counterparty

Term

One-year

Single/multi yr. Single/multi yr.

Payment Trigger

Indemnity

Index based

Covered Perils Virtually any op Natural/manrisk made risks

Pre defined, timely issuance of securities Natural/man made risks.

Summary of Risk Transfer Solutions

Type of Exposure Level of Exposure

Low Expected Medium

High

Risk Solution Yearly Profits/Internal controls Yearly profits/controls/Art Art, Self Insure, Insurance

Advantages  



Cash flow



Diversification Pooling Established Mechanism

 

Unexpected Catastrophic

Capital markets, government, insurance & capital market hybrid

Operating Group focus Efficient

 

Long-term Access to very large pool of capital

Questions Michel Rochette, MBA ENTERPRISE RISK ADVISORY, LLC 954-607-6969 michel.rochette@enterprise-risk-advisory.com