Operational risk transfer across financial sectors

August 2003

The Joint Forum of banking, securities, and insurance supervisors has been engaged in an effort to better understand risk management practices across all three sectors. In November 2001, the Joint Forum produced a report on Risk Management Practices and Regulatory Capital: Cross-Sectoral Comparison (November 2001 Joint Forum paper) that compared approaches to risk management and capital regulation across the sectors.

One of the issues highlighted in the paper was the need for supervisors to explore issues surrounding cross-sectoral risk transfer. While the November 2001 Joint Forum paper discussed the full range of risks that may be transferred across sectors, this report specifically focuses on the transfer of operational risk.

Banks, securities firms, and insurers - as well as their supervisors - have paid increasing attention to operational risk in recent years. This has been driven by a number of factors, including the large number of high-profile operational loss events that have occurred in recent years, the desire to increase shareholder value, and heightened supervisory attention.

The purpose of this paper is to foster dialogue amongst financial firms and supervisors around issues related to the transfer of operational risk across financial sectors, both within a financial conglomerate and to third parties. Transfer of risk - especially credit risk - across sectors has received increasing attention from supervisors and market participants in recent months, but comparatively little attention has been paid to the transfer of operational risk. The Working Group hopes that this paper and the ensuing dialogue will foster greater understanding on the part of firms and supervisors with regard to the issues underpinning operational risk transfer.

This paper will look at current and emerging industry practices, including definitions of operational risk and loss event types. The nature of insurable risks, which are most readily transferable, will be discussed. Some of the factors that drive operational risk management, including regulatory requirements (e.g., capital), the trade-off between risk and return, and the importance of mitigating the impact of low-frequency, high-severity loss events will also be discussed.

While the report notes a range of possible instruments for transferring operational risk, much of the report will focus specifically on insurance coverage. Insurance is not the only form of operational risk transfer, but because it is so widely used and is particularly relevant to the cross-sectoral work of the Joint Forum, much of the discussion will naturally centre on insurance practices and concepts.

The paper will consider a range of issues that should be taken into account by both firms and supervisors in assessing the effectiveness of operational risk transfer across sectors. These issues will be considered from the perspective of both the protection buyer and the protection seller. Firms that are buying protection should consider the extent to which operational risk is transformed to counterparty credit, liquidity, legal, or basis risk; continuing coverage guarantees (including term of remaining coverage and any insurer cancellabilityrights or renewability options); and, if applicable, the impact of transfer to related parties. Protection sellers should have the ability to assess the operational risks they assume; take into account potential correlations; manage concentration risks; and address moral hazard issues.

Supervisors are interested in the extent to which differences in economic or regulatory capital methodologies may drive risk transfer. In this regard, a highly simplified stylised example is presented to illustrate how recognition of insurance may affect capital requirements for both a protection buyer and protection seller.

A series of supervisory issues are raised for further consideration. Among these issues are the importance of sound management on the part of both protection buyers and sellers; potential capital arbitrage; the importance of managing risk concentrations; intra-group risk transfers; reinsurance; and transparency.

Finally, the report presents a set of conclusions. Supervisors and firms should understand better the effectiveness of operational risk transfer mechanisms and the attendant risks which may arise from such mechanisms. Firms that take on risk should have in place adequate risk management and measurement systems. Supervisors should share information within and across sectors to most effectively keep pace with developments in the market for operational risk transfer. Protection sellers are encouraged to focus efforts on improving existing operational risk transfer products rather than attempting to develop new products which offer broader "basket" coverage. To the extent that such products are developed, supervisors should monitor the use of such products. Finally, supervisors should consider the potential systemic implications of low-frequency, high-severity events which may be uninsured or uninsurable.