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Insurers need capital to provide for operational risk

28 October 2010 Aon
Slavica Lazic, a Consulting Actuary at Aon South Africa

Slavica Lazic, a Consulting Actuary at Aon South Africa

The world-wide increase in awareness of the importance of risk management to corporate governance has been magnified following the recent financial crisis. It has been widely agreed that inadequate risk management played a strong contributing role to financial institutions' lack of awareness of their exposures to credit risk.

Slavica Lazic, a Consulting Actuary at Aon, says it is encouraging to see that South African insurance companies have stepped-up their efforts to implement risk management frameworks, which include operational risks. While these have often been headed by Chief Risk Officers, with input from different company departments, it is envisaged that moving forward this function will increasingly fall on the shoulders of actuaries with Enterprise Risk Management (ERM) qualifications. "Actuaries are now able to assist insurance companies in reviewing their risk management strategy and in quantifying the capital which the strategy requires or implies," she says.

The actuarial profession has increasingly become more focused on the importance of monitoring operational risk and understanding the risk management processes of the insurer to ensure the company's solvency in adverse market conditions. "Operational risk, as considered for an insurer's solvency purposes, is effectively the risk of loss arising from inadequate or failed internal processes, people, and systems or from external events,"

says Lazic.

Some of the larger insurance companies have already developed their own internal models that are able to capture the specific risks that the company faces, including operational risks. These models are used primarily for the determination of capital requirements, though the benefits extend to enhancing the various decision-making processes. For insurance companies that have not developed internal models, Lazic says various formulae have been put forward to determine the capital to set aside for operational risk.

"However," says Lazic, "tackling the operational risk is a fairly new discipline for the actuarial profession. The formulae put forward so far are still very simplistic and do not really cater for the variety of operational risks that a particular insurance company may encounter. Nevertheless, this does not diminish the usefulness of developing these methodologies."

She says that while it is important to try and quantify the impact that operational risk may have on a business and hence ensure its solvency in adverse conditions, it is just as crucial to be aware of the existence and variety of these risks, even if one cannot quantify them as yet. "If we have learnt anything from the recent financial crisis, it is that we should never simply rely on the numbers produced by formulae, no matter how sophisticated they get - there always needs to be space for qualitative assessment," she says.

The development in this area has also been driven by the Solvency II framework for insurance companies being developed for the EU Commission, which has in turn taken some of the findings from the Basel II Capital Accord for the European banking sector.

The Financial Services Board (FSB) is in the process of developing a new solvency regime, the Solvency Assessment and Management (SAM) for the South African long-term and short-term insurance industries to be in line with international standards. The target date for SAM's implementation is 2014.

Lazic says one of the aspects that the SAM regime will promote is the use of internal capital models for the assessment of the statutory capital requirement. "This will require a thorough understanding of the specific risks and exposures faced by the company as a first step in modelling these risks and understanding the company's risk management capabilities.

Operational risk is one of the elements for which a capital requirement needs to be assessed," she says.

"Given the impending arrival of SAM and the complex nature of these risks, it is important for insurers to start considering this aspect now to avoid unforeseen capital strains," she concludes.

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