25.1 ERA 4.1 Operational Risk Intro

Important cause of insurer insolvency \(\Rightarrow\) Need to be aware and attempt to measure

Definition 25.1 (Basel Op-Risk Definition)

The risk of loss resulting from inadequate or failed internal process, people, and systems or from external events

  • Include legal risk

  • Exclude strategic and reputation risk

7 Types of Operational Risk Defined by Basel Committee

  1. Internal fraud

    • Acts that are intended to defraud, take property, or circumvent: regulations, law, or company policy

    • Includes at least one internal party

  2. External fraud

    • Acts by a 3rd party that are intended to defaud, take property, or circumvent the law

  3. Employment practices and workplace safety

    • Acts inconsistent with: employment health, safety laws or agreements, which result in payment for: injury, claims for diversity of discrimination issues

    • e.g. repetitive stress, discrimination

  4. Clients, products and business practices

    • Unintentional or neligent failure to meet a professional obligation to specific clients

    • Nature of design of a product

    • e.g. client privacy, bad faith

  5. Damage to physical assets

    • Loss of damage to physical assets from natural disaster of other events

    • e.g. Physical damage to office, own auto fleets

  6. Business disruption and system failures

    • Discruption of business of system failures

    • e.g. processing center downtime, system interruptions, flood

  7. Execution, delivery and process management

    • Failed transaction processing or process management

    • Relations with trade counterparties and vendors

    • e.g. policy processing, claims payment errors

Remark.

  • Definition of op-risk has gained substantial visibility in ERM

    • For insurance though, the debate is always on going whether it is worth while to hold capital for op-risk

    • Different from banking, insurance op-risk are already baked into the other risk categories we measure and manage

  • But still no consensus on how to define op-risk

  • Could include reputational and strategic risk (just have a consistent risk taxonomy)

  • Understanding of op risk is in its infancy especially with quantitative modeling

  • Do not lose sight of op risk despite it is soft, difficult, poorly understood and lack historical track record