Operational risk losses are high profile, uncertain, and headline-grabbing. Despite the best endeavours of companies, material operational risk losses keep occurring. In the insurance sector, operational risk losses tend to be less dramatic than in banking, measured in the hundreds of millions rather than billions, and with losses crystallising over a longer period. It is therefore appropriate from an economic perspective, and mandatory from a regulatory perspective, to hold capital against this risk.
For Canadian federally regulated insurers, operational risk is a key risk that is required to be explicitly addressed within their own risk and solvency assessment (ORSA). Some provincial insurance regulators have also adopted the federal or similar ORSA guidelines as part of their supervisory framework. In addition, Qubec-regulated insurers are required to account for operational risk when establishing their target capital ratio.
Research and surveys indicate that (globally) insurers have not historically directed as much time and effort to analyzing, modeling, and quantifying operational risk as they have for other categories of risk, such as insurance risk and asset-related risks. There is, however, a trend towards greater regulatory attention directed at the potential effect of operational risk for financial institutions; and as a result, insurers have recently begun to focus on how operational failures can affect their business. Consequently, methods for modeling operational risk capital are being developed, and the literature supporting such methods is being published at a greater rate than in the past.
The Canadian Institute of Actuaries (CIA) Committee on Risk Management and Capital Requirements (CRMCR) issued a request for proposals (RFP) in the fall of 2013 for the publication of a research paper addressing approaches to modeling operational risk capital for insurers.2 Funding for this research project is provided by the CIA Research Committee.