Review of Capital Adequacy Requirements for Operational Risk (Orca) for Insurance Companies

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The main objective of the review is to analyse the assessment of operational risk in life insurance companies and the process to develop a framework to assess the capital requirements relating to operational risk, taking into account the capital requirements of other risks and their interaction.

What is Operational Risk?
Operational Risk is one of the six risk categories in the Prudential Sourcebook (PSB), along with credit risk, market risk, liquidity risk, group risk and insurance risk. It is described as "the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events".

Benefits from assessing, monitoring and controlling organisations Operational Risk exposures: Management can make conscious decisions about what risks they want to accept, what risks they want to eliminate or reduce and what risks they wish to transfer. By measuring the risks, the benefits of their actions can be monitored. By analysing the Operational Risk losses, trends can be identified, lessons can be learned and appropriate action can be taken. Management controls can be enhanced to reduce the possibility of losses.

Operational Risk CAR Challenges:
The risks involved, and their individual circumstances and loss amounts, are potentially extremely varied and relatively infrequent in occurrence. Operational risks are typically long-tailed and model results can be highly sensitive to assumptions. Defining what an Operational Risk (OR) loss is. An OR event can impact many aspects of an insurance company’s operations, particularly claims and expense experience. It is not easy to separate out how much of the experience variations are as a result of OR events. It is not always easy to identify what the impact is or has been once an OR event has been identified. Therefore the data that one might want for rigorous statistical analysis and modeling of OR is not currently available and in some cases never will be. Applying quantitative approaches, therefore, can be highly false, and one needs to evaluate the results accordingly. In practice OR may be assessed outside the Actuarial function. However, Risk Management professionals will typically work in conjunction with the Actuarial function to quantify OR. Actuaries should be well placed to support the assessment. There will be some allowance for OR events within the data informing the actuarial models used to assess the capital requirements for insurance and other risks and it is important to understand the dependencies.

3.ORCA Process
1.Identify and understand operational risks and impacts
2.Decide which operational risks require capital
3.Specify model and information requirements
4.Aggregate with capital from other risks
5.Set inputs to the model:
Consider loss and near-miss data
Consult with business on individual risk scenarios
Develop combined risk scenarios and identify correlations 6.Model the OR losses and set appropriate OR capital requirement 7.Communicate results to Senior Management
8.Use ORCA to manage risks
9.Annual review and Future Developments.
The highlighted steps are applicable to risk management. Capital modelling is done by the actuarial department however the risk management professionals need to work in conjunction with the actuaries to quantify and model the operational risks.

4.Identify and understand operational risks and impacts
A robust and comprehensive risk identification process is fundamental to the capital assessment. The identification of OR’s may start with high-level risk categories in the definition of OR, namely people, processes, systems and external events. The organisation should then identify levels of sub-risks which reflect its individual circumstances, history, culture and organisational structure. The important point is that, as far as possible, all the organisation’s risks are included and that the...
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