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Basel III and Operational Risk

Financial, Executive and Professional Risks (FINEX)
COVID 19 Coronavirus

By Alexandra Cosma and Charlotte McDermottroe | October 20, 2020

Can insurance reduce the operational risk capital that financial institutions need to hold under Basel III?

Basel III and Operational Risk

Effective January 2023, following a one year deferral due to the COVID-19 pandemic, Basel III1 aims to build upon the previous two Basel accords to strengthen regulation, risk management, supervision and stability within the banking industry.

Although this new accord presents changes to many of the regulated risks, this article focuses on operational risk management and specifically on the calculation of capital requirements and the role of insurance.

Minimum capital is calculated based on the new Standardised Approach

Basel III sets a revised Standardised Approach (“SA”) framework to calculate minimum Operational Risk Capital (“ORC”) requirements. This replaces the three calculation methods part of Basel II (one of these being the Advanced Measurement Approach) and, in doing so, is expected to improve comparability across banks. The SA formula is a function of a bank’s income (captured through a Business Indicator) and historical losses (captured through the Internal Loss Multiplier), and, as such, is predicted to affect banks to varying degrees.

The new SA applies to all internationally active banks on a consolidated basis, and national supervisors may also apply the framework to non-internationally active banks. For example, the European Union is not limiting the application of the Basel III reforms to only internationally active banks but will apply them across its financial sector to cover all banks and investment firms.2 It is worth noting that different prudential regulators may hold different views regarding the extent of desired implementation, which will likely result in differences across geographies.

Data, data and more data

As historical loss data factors in the ORC calculation, banks are required to have a high-quality loss database, capturing a plenitude of information, such as the nature of loss events, important dates (date of occurrence, date of discovery etc.), and a corresponding Basel Level 1 risk 'event type' category etc. If banks fail to meet these data quality standards, supervisors may require that the minimum capital requirement should not consider the bank’s historical losses (which if included, could decrease the ORC). Further, all banks with a Business Indicator3 greater than €1billion and / or which utilise loss data in the capital calculation are required to reveal their loss data (which can be for a 10 year window or less, depending on the national supervisor’s review of the quality of data) on a gross basis and after recoveries.

Change in capital following the introduction of SA

In general, under the new SA, banks with a sound risk management framework, and a correspondingly low relative level of historical operational losses, will be required to hold comparatively less capital than similar-sized banks with a more turbulent loss history. Whilst many banking groups have recently suspended dividend payments under guidance from regulators, in an effort to boost lending throughout the COVID crisis, the medium-term focus for banks will remain on capital optimisation as they combat continued low interest rates and credit impairments.

Based on a study performed by the European Banking Authority4, it is estimated that the implementation of Basel III will result in an increase of 23.6% in the minimum required total capital of European banks (with respect to the June 2018 baseline). Operational risk capital increase accounts for 3.3%. The same study suggests that the new SA is expected to cause a much greater capital increase for larger European institutions than small-medium firms.

The implementation of suitable risk management frameworks should be viewed as an incentive for all banks as a means of lowering operational risk losses and so the level of ORC. Whilst good risk management can indirectly influence the minimum capital, insurance recoveries do so directly.

The role of insurance

Historical operational risk losses will feed into the new SA formula as the average net annual operational losses calculated for the 10-year window preceding the year for which the capital requirements will be in effect. Banks can therefore net out the amounts that they have recovered on operational loss events, including the insurance pay-outs received. The netting of recoveries follows the logic that, because recoveries reduce the financial losses of a firm, they reduce its operational loss exposure and thus should reduce the proxy for operational loss exposure used in the SA.

This image illustrates an overview of how insurance works.
This image illustrates an overview of how insurance works.

Factoring insurance into capital calculations is not a new concept. Under Basel II, this is performed via internal models, subject to Advanced Measurement Approach (“AMA”) requirements and national regulatory approval. Insurance is similarly factored into Pillar 2 / economic capital model-based calculation under Basel II and is continuing through Basel III. Under the new regime, the difference is that under Pillar 1 the SA includes tangible historical recoveries, rather than forward-looking statistical estimations (as for Pillar 1 AMA and Pillar 2 under Basel II).

Key questions answered

Should companies expect to have higher or lower insurance recoveries under SA than previously accounted for under AMA?

The overall mitigation cap under AMA was 20% of the total capital requirement, including insurance and other recoveries. Willis Towers Watson insurance performance data5 suggests that historically 12% of the total losses suffered by financial institutions were funded by insurers. Recoveries for some of the biggest banking losses can be significantly lower to zero, especially where these involved typically uninsurable regulatory events such as fines e.g. for anti-money laundering failures. Therefore, this percentage depends heavily on the type of losses considered. It is interesting to note that Willis Towers Watson data suggests that a much larger percentage could hypothetically have been recovered by financial institutions, amounting to 67% of the total historical loss amount, but 55% of it was retained (as the losses fell under the deductible or above the limit). Therefore, we recommend that firms invest more resources in ensuring that deductibles and limits are not only driven by market pricing and capacity but are also in line with their loss history, risk appetite/tolerance and future expectations.

Will there be a different focus on insurance?

We expect to see an increased focus on the return on investment of insurance as firms will get a clear picture of their total recoveries as a percentage of the total loss suffered. Firms will want to start by ensuring their insurance policies are suitable to their risk profile. Traditional insurance policies which are associated with operational risk coverage include: Professional Indemnity, Crime, Cyber, Directors & Officers, Employment Practices Liability, Business Interruption, etc. There are also alternative products on the market, which are built ad-hoc such as operational risk insurance policies. But, irrespective of the nomenclature, what matters the most is that the policy contracts have suitable wording and structure to minimise the gaps in coverage. We therefore expect financial institutions to place a greater focus on how insurance links to their risk.

Insurance is normally sought to cover losses which are statistically unexpected, expected losses being usually mitigated through internal controls. Marco Migueis at the Federal Reserve focuses on the risk of regulatory arbitrage that can arise from the new SA: “Given that net annual operational losses are calculated net of insurance recoveries, the regulation incentivizes banks to purchase insurance policies. But insurance does not need to focus on reducing exposure to large tail loss events to be successful in reducing average net annual operational losses. Instead, banks may be able to achieve meaningful regulatory capital reduction through insurance policies that cover recurring losses”6. It is worth noting that purchasing insurance at an ‘arbitrage’ level (assuming insurance market conditions allow for it) might create a disconnect between a bank’s risk appetite/tolerance and the level of retention set under an insurance policy.

Other variables that require scrutiny and efficiency measures are the settlement time and the timeliness of payment i.e. from agreed by insurers to fully paid. This is because insurance recoveries can be subtracted from gross losses only after they have been paid out. Certain events take longer to be agreed and paid out, and certain insurers and insurance markets are more efficient in this process.

Does this mean that there is no place for Pillar 2 insurance integration under Basel III?

Our expectation is that firms will continue integrating insurance estimates within their Pillar 2 calculations for the years to come after the application of Basel III, as this encourages them to consider insurance on a forward-looking, unexpected loss basis which in turn can promote effective risk management and appropriate insurance product development.

Willis Towers Watson: A trusted risk management partner

Making the most out of your insurance to reduce Operational Risk Capital (ORC) requirement

Through aligning insurance to your specific risk profile, the chance of higher recoveries increases, thus potentially reducing the firm’s net operational losses and the ORC. Subject to market capacity, a firm should buy enough insurance to cover its risk profile; buying too much is a waste of premium whilst buying too little exposes the firm to increased risk. Our Operational Risk Solutions team works with clients to link their insurance buying strategy to their risk profile, considering the insurability of their risks, their risk appetite and the cost of insurance. Not all operational risks are insurable, and it is therefore important that the insurance limits are maximised where possible to cover the insurable aspects of a firm’s risk. This process includes clearly outlining how insurance would be expected to respond and where changes to wordings or new policies would increase coverage.

Making the most out of your insurance to reduce your Operational Risk Pillar 2 / economic capital

Willis Towers Watson has successfully worked with financial institutions and investment firms regulated by the PRA and FCA in the UK and in other regulatory jurisdictions to integrate insurance within their Pillar 2A / Internal Capital Adequacy Assessment Process.

Claims advocacy

Willis Towers Watson’s Global Financial Institutions Claims Advocacy practice works with clients and their counsel to seek to maximise claims recoveries. Our experienced team, who specialise in the intersection of financial institutions litigation, regulation and insurance recoveries, advise clients on the operation of their insurance contracts. We work with clients on pre-claim advice and training in order to seek to avoid the most common pitfalls, such as late notification, and then develop and execute a strategy to progress each claim in accordance with insurers’ expectations. When necessary, in the face of denial of coverage or attempts by insurers to limit recoveries, we advise on and lead negotiations with insurers.

Improve your operational risk management

Willis Towers Watson’s Operational Risk Solutions team helps firms of all sizes to enhance their operational risk framework and manages projects that include operational risk assessment, gap analysis, statistical modelling, model validation, insurability analysis.

To discuss this further, please get in touch.

Footnotes

1 BIS (2017). Basel Committee on Banking Supervision. Basel III: Finalising post-crisis reforms. ISBN 978-92-9259-022-2 Available online: https://www.bis.org/bcbs/publ/d424.pdf

2 European Commission (2011). MEMO/11/527 CRD IV – Frequently Asked Questions. Available online: https://ec.europa.eu/commission/presscorner/detail/fr/MEMO_11_527

3 The business indicator is a financial-statement-based proxy for operational risks.

4 EBA (2019). Basel II Reforms: Impact Study and Key Recommendations. Available online: https://eba.europa.eu/sites/default/documents/files/document_library//Basel%20III%20reforms
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%20assessment%20credit%20valuation%20adjustment%20and%20market%20risk.pdf

5 Willis Towers Watson’s key proprietary claims database, Intelligence & Risk Insight, is comprised of 37,000 insurance notifications made to FINEX Global since 2008. We exploit the power of this data to provide detail claims analysis to our clients which, whilst maintaining confidentiality, illustrates important details about the nature, trends, causes and cost breakdown of loss events.

6 Migueis, M., (2020). Regulatory Arbitrage in the Use of Insurance in the New Standardized Approach for Operational Risk Capital. Federal Reserve. Available online: https://www.federalreserve.gov/econres/notes/feds-notes/regulatory-arbitrage-in-the-use-of-insurance-in-the-new-standardized-approach-for-operational-risk-capital-20200330.htm

Authors

Operational risk solutions, FINEX

Client Project Management Consulting

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Alexandra Kindbom
Canada Head of FINEX Financial Institutions

Susan Finbow
Global Head of Financial Institutions

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