Operational risk management in the short-term insurance industry and risk based capital

Abstract

Operational risk management has been identified as one of the primary risk types that short-term insurance companies will have to deal with on a rigorous basis in the future. The implied future importance of operational risk management to short-term insurance companies has come about due to the South African Financial Services Board’s decision to develop and institute a new solvency regime for the South African short-term insurance industry. The South African Financial Services Board has decided to implement a risk based capital approach to insurance company solvency requirements in line with approaches adopted in the European Union. The new proposed risk based capital solvency requirements are being designed to ensure that insurers have sufficient capital to withstand adverse events, both in terms of insurance risk, as well as in terms of economic, market and operational risk. A key divergence from the current capital regime is that under a risk based capital approach insurers will have to put rigorous risk management strategies into practice and to consider all the risks that may affect their business, including operational risks, and not only the underwriting risks. Under the current solvency regime many insurance companies pay scant attention to operational risk. Solvency Assessment and Management aims to create a more realistic measure of solvency capital requirements based on all the risks an insurer faces, including all categories of risk and in particular bringing in the effect of operational risk. In light of the above, this study, which consists of a literature review as well as experiential research in the form of a survey, was conducted: • To identify and present the various elements, practices, processes, techniques and methods that can and should be recognised, considered and employed by insurers in terms of their operational risk management programmes. • To investigate insurers current approaches, as well as their recommended views, towards the recognition, consideration and use of various elements, practices, processes, techniques and methods employed in operational risk management practice. • To investigate whether insurers approaches and views towards operational risk management, and their recognition, consideration and use of various elements, practices, processes, techniques and methods employed in operational risk management are being significantly altered by the current importance being attached to operational risk management as part of the requirements of the Solvency Assessment and Management risk based capital regime being implemented in 2014. The literature review delineated operational risk as being the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events; and operational risk management as consisting of a continuing process of operational risk identification; measurement and evaluation; mitigation and control; and monitoring and reporting by means of various practices, processes, techniques and methods of operational risk management. The results of the research indicate that insurers approaches and views towards operational risk management, and their recognition, consideration and use of various elements, practices, processes, techniques and methods employed in operational risk management are being significantly altered. In the majority of instances, insurers current approaches towards the recognition, consideration and use of various elements, practices, processes, techniques and methods employed in operational risk management practice differed significantly from their recommended views. It is this author’s opinion that a major contributor to this phenomenon is the current importance being attached to operational risk management as part of the requirements of the Solvency Assessment and Management risk based capital regime being implemented in 2014. Due to operational risk management in the short-term insurance industry being a relatively new concept still in a developmental stage, it is this author’s opinion that this study could assist short-term insurers with founding formal operational risk management processes and programmes within their organisations, and key recommendations are: A structured approach to operational risk management should be instituted by short-term insurers. • In line with a structured approach, the framework, practices, processes, techniques and methods identified and described by this study should be implemented by short-term insurers in designing and instituting their own operational risk management programmes. • The adoption / institution of a structured, formalized operational risk management programme / processes should be commenced as soon as possible so that insurers can begin managing the operational risks inherent in their businesses to an optimal level. • The adoption / institution of a structured, formalized operational risk management programme / processes should be commenced as soon as possible so as to integrate operational risk management processes and practices as well as an operational risk management culture into insurers businesses well in advance of the implementation of the SAM risk based capital regime. • The adoption / institution of a structured, formalized operational risk management programme / processes should be commenced as soon as possible so that insurers are in a position to comply regulatorily with the pending SAM risk based capital regime which is being implemented on the 01st of January 2014. • The adoption / institution of a structured, formalized operational risk management programme / processes should be commenced as soon as possible so that insurers have practiced, embedded and integrated structured operational risk management processes and practices into their businesses to such a degree that they are able to completely satisfy the regulator’s (FSB) requirement of the insurer’s operational risk management programme passing a “use” test at the time of the introduction of the SAM risk based capital regime on the 01st of January 2014. The main recommendation for further study emanating from the research is for research to be conducted on insurers approaches towards operational risk management at the time of the Solvency Assessment and Management regime implementation on 01st January 2014, to assess their levels of institutionalization of formal operational risk management programmes at the time.