Abstract
In broad terms, risk management (RM) covers four conventional actions in addressing operational risks (OpRisks), i.e., actions to mitigate, eliminate, accept, and transfer operational risks. In relation to transferring OpRisks to external third parties, this study aids chief risk officers (CROs) in addressing issues related to the reduction of economic exposure to OpRisk. In this respect, the economic handling of OpRisks and their coverage through specific insurance programs are among the major challenges that CROs face within their roles. The aim of this paper is to provide CROs with an analytical pathway to addressing these challenges by applying the total cost of risk (TCoR) method tailored to their purposes. Through a leading example, this paper demonstrates that the TCoR approach meaningfully and productively supports CROs’ decisions when striving to deal with OpRisk. In fact, the TCoR approach implementation, together with the application of Monte Carlo simulation as a computational tool, drives TCoR value optimization when OpRisk is transferred to insurance agencies. In addition, by applying a TCoR framework, CROs can find the correct and cost-effective balance between the company’s retention level—consistent with the company’s risk appetite—and the premiums paid to insurance agencies. In conclusion, this paper provides CROs with a methodological approach for efficiently building relationships with insurance agencies by consistently addressing TCoR-based dealings.
Highlights
The purpose of this paper is to analyze the handling of operational risks (OpRisks) when they are transferred to insurance agencies from an economic standpoint
Among the different OpRisk classes projected by Basel II and introduced in “Analysis of the reference scope”, the propositions of this paper are applicable to all insurable risks that can be quantified through historical loss data
chief risk officers (CROs) perform the optimization of OpRisk costs through qualitative approaches based on their risk appetite and risk capacity
Summary
The purpose of this paper is to analyze the handling of operational risks (OpRisks) when they are transferred to insurance agencies from an economic standpoint. In Basel II/III, OpRisk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This definition includes legal risk but excludes strategic and reputational risk” (Basel Committee 2004). The China Risk Orientated Solvency System (C-ROSS) conceptual framework, issued by the China Insurance Regulatory Commission (CIRC), analogously quotes “The risk of direct or indirect losses due to inadequate internal processes, personnel and systems or from external events, including legal and supervisory compliance risk—but excluding strategic risk and reputational risk” (CIRC C-ROSS Conceptual Framework 2013).
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