Fabio Piacenza

Modeling insurance mitigation on operational risk capital

One defines operational risk as the loss resulting from inadequate or failed internal processes, people and systems or from external events (see Basel Committee on Banking Supervision (2004)). Operational risk quantification has become increasingly important for financial institutions since the New Basel Capital Accord first consultative paper. According to the New Basel Capital Accord (see Basel Committee on Banking Supervision (2004)), the capital charge for operational risk can be calculated using three alternative methods: the basic indicator approach (BIA), the standardized approach (TSA) and the advanced measurement approach (AMA). The first two methods are a function of gross income, while the advanced method is based on internal loss data, external loss data (see Baud et al (2002a,b) and Frachot and Roncalli (2002)), scenario analysis, business environment and internal control factors.1 A specific feature of AMA models, compared to BIA and TSA, is the potential recognition of insurance as a percentage of the operational risk

Standardized measurement approach extension to integrate insurance deduction into operational risk capital requirement

The consultative document issued by the Basel Committee on Banking Supervision (BCBS) in March 2016 proposes the withdrawal of internal modeling for operational risk regulatory capital and describes the new proposed methodology for calculating operational risk capital requirement: the standardized measurement approach (SMA). One of the main problems with the SMA is that it does not allow the inclusion of insurance coverage as capital requirement deduction. As a direct consequence, the SMA offers no incentives to invest in insurance coverage in order to keep the risk profile under control. Even the incentive to invest in other mitigation actions is reduced, since forward-looking components are not considered and it takes several years to significantly affect the SMA capital requirement through loss reduction. This paper describes a possible proposal to extend the SMA to include insurance coverage. The operational risk capital-at-risk (OpCaR) model, probably the same one used to calibrate the SMA, is a natural choice for integrating insurance coverage into the extended SMA. The OpCaR model is defined and used by regulators, and it can be easily implemented by all banks, as it is clearly described in the BCBS consultative paper “Operational risk: revisions to the simpler approaches”.