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Solvency ii and Operational Risk
from the Solvency ii Association, the largest Association of Solvency ii Professionals in the world
 
Operational risk is a neglected area in the insurance and reinsurance industry that becomes a major concern after the Solvency ii Directive of the European Union.
 
Although operational risk is one of the major threats to the solvency of insurers and reinsurers, and it is a separate risk category under Solvency II, it is not well understood. 
 
From the European Parliament legislative resolution of 22 April 2009 on the amended proposal for a directive of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (recast)

        (27)  Operational risk means the risk of loss arising from inadequate or failed internal processes, or from personnel and systems, or from external events;

       Article 43
Risk management


1. Insurance and reinsurance undertakings shall have in place an effective risk management system comprising strategies, processes and reporting procedures necessary to identify, measure, monitor, manage and report, on a continuous basis the risks, on an individual and aggregated level, to which they are or could be exposed, and their interdependencies.

That risk management system shall be effective and well integrated into the organisational structure and in the decision making processes of the insurance or reinsurance undertaking with proper consideration of the persons who effectively run the undertaking or have other key functions.

2. The risk management system shall cover the risks to be included in the calculation of the Solvency Capital Requirement as set out in Article 101(4) as well as the risks which are not or not fully included in the calculation thereof.

It shall cover at least the following areas:

(a) underwriting and reserving;

(b) asset – liability management;

(c) investment, in particular derivatives and similar commitments;

(d) liquidity and concentration risk management;

(da) operational risk management;

(e) reinsurance and other risk mitigation techniques.

The written policy on risk management referred to in Article 41(3) shall comprise policies relating to points (a) to (e) of the second subparagraph of this paragraph.


        Article 48
Outsourcing


1. Member States shall ensure that, when insurance and reinsurance undertakings outsource functions or any insurance or reinsurance activities, the undertakings remain fully responsible for discharging all of their obligations under this Directive.

2. Outsourcing of critical or important operational functions or activities shall not be undertaken in such a way as to lead to any of the following:

(a) impairing materially the quality of the governance system of the undertaking concerned;

(b) increasing unduly the operational risk;

(c) impairing the ability of the supervisory authorities to monitor the compliance of the undertaking with its obligations;

(d) undermining continuous and satisfactory service to policyholders.

3. Insurance and reinsurance undertakings shall, in a timely manner, notify the supervisory authorities prior to the outsourcing of critical or important functions or activities as well as of any subsequent material developments with respect to those activities.


       Article 101
Calculation of the Solvency Capital Requirement


1. The Solvency Capital Requirement shall be calculated in accordance with paragraphs 2 to 5:

2 The Solvency Capital Requirement shall be calculated on the presumption that the undertaking will carry on its business as a going concern.

3. The Solvency Capital Requirement shall be calibrated so as to ensure that all quantifiable risks to which an insurance or reinsurance undertaking is exposed are taken into account. It shall cover existing business, as well as the new business expected to be written over the next twelve months. With respect to existing business, it shall cover unexpected losses only.

It shall correspond to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99,5 % over a one-year period.

4. The Solvency Capital Requirement shall cover at least the following risks:

(a) non-life underwriting risk;

(b) life underwriting risk;

(c) health underwriting risk;

(d) market risk;

(e) credit risk;

(f) operational risk.

Operational risk as referred to in point (f) of the first subparagraph shall include legal risks, and exclude risks arising from strategic decisions, as well as reputation risks.

5. When calculating the Solvency Capital Requirement, insurance and reinsurance undertakings shall take account of the effect of risk mitigation techniques, provided that credit risk and other risks arising from the use of such techniques are properly reflected in the Solvency Capital Requirement.


        Article 103
Structure of the standard formula


The Solvency Capital Requirement calculated on the basis of the standard formula shall be the sum of the following items:

(a) the Basic Solvency Capital Requirement, as laid down in Article 104;

(b)
the capital requirement for operational risk, as laid down in Article 106;

(c) the adjustment for the loss-absorbing capacity of technical provisions and deferred taxes, as laid down in Article 107.


       Article 104
Design of the Basic Solvency Capital Requirement


1. The Basic Solvency Capital Requirement shall comprise individual risk modules, which are aggregated in accordance with point 1 of Annex IV.

It shall consist of at least the following risk modules:

(a) non-life underwriting risk;

(b) life underwriting risk;

(c) health underwriting risk;

(d) market risk,

(e) counterparty default risk.


2. For the purposes of points (a), (b) and (c) of paragraph 1, insurance or reinsurance operations shall be allocated to the underwriting risk module that best reflects the technical nature of the underlying risks.

3. The correlation coefficients for the aggregation of the risk modules referred to in paragraph 1, as well as the calibration of the capital requirements for each risk module, shall result in an overall Solvency Capital Requirement which complies with the principles set out in Article 101.

4. Each of the risk modules referred to in paragraph 1 shall be calibrated using a Value-at-Risk measure, with a 99.5% confidence level, over a one year period.

Where appropriate, diversification effects shall be taken into account in the design of each risk module.

5. The same design and specifications for the risk modules shall be used for all insurance and reinsurance undertakings, both with respect to the Basic Solvency Capital Requirement and to any simplified calculations as laid down in Article 108.

6. With regard to risks arising from catastrophes, geographical specifications may, where appropriate, be used for the calculation of the life, non-life and health underwriting risk modules.

7. Subject to approval by the supervisory authorities, insurance and reinsurance undertakings may, within the design of the standard formula, replace a subset of its parameters by parameters specific to the undertaking concerned when calculating the life, non-life and health underwriting risk modules.

Such parameters shall be calibrated on the basis of the internal data of the undertaking concerned, or of data which is directly relevant for the operations of that undertaking using standardised methods.

When granting supervisory approval, supervisory authorities shall verify the completeness, accuracy and appropriateness of the data used.


        Article 106
Capital requirement for operational risk

1.
The capital requirement for operational risk shall reflect operational risks to the extent they are not already reflected in the risk modules referred to in Article 104. That requirement shall be calibrated in accordance with Article 101(3).

2. With respect to life insurance contracts where the investment risk is borne by the policyholders,
the calculation of the capital requirement for operational risk shall take account of the amount of annual expenses incurred in respect of those insurance obligations.

3. With respect to insurance and reinsurance operations other than those referred to in paragraph 2, the calculation of the
capital requirement for operational risk shall take account of the volume of those operations, in terms of earned premiums and technical provisions which are held in respect of those insurance and reinsurance obligations.

        In this case, the capital requirement for operational risks shall not exceed 30% of the Basic Solvency Capital Requirement relating to those insurance and reinsurance operations.


        Article 109
Implementing measures


1. In order to ensure that the same treatment is applied to all insurance and reinsurance undertakings calculating the Solvency Capital Requirement on the basis of the standard formula, or to take account of market developments, the Commission shall adopt implementing measures laying down the following:

(-a) a standard formula in accordance with the provisions of Articles 101 and 103 to 108;

(a) any sub-modules necessary or covering more precisely the risks which fall under the respective risk modules referred to in Article 104 as well as any subsequent updates;

(b) the methods, assumptions and standard parameters to be used, when calculating each of the risk modules or sub-modules of the Basic Solvency Capital Requirement laid down in Articles 104 and 105, the symmetric adjustment mechanism and the appropriate period of time, expressed in the number of months, as referred to in Articles 105a and 305b, as well as the appropriate approach for integrating the method referred to in Article 305b related to the use of this method in the Solvency Capital Requirement as calculated in accordance with the standard formula;

(c) the correlation parameters, including, if necessary, those set out in Annex IV, and the procedures for the updating of those parameters;

(d) where insurance and reinsurance undertakings use risk mitigation techniques, the methods and assumptions to be used to assess the changes in the risk profile of the undertaking concerned and adjust the calculation of the Solvency Capital Requirement;

(e) the qualitative criteria that the risk mitigation techniques referred to in point (d) must meet in order to ensure that the risk has been effectively transferred to a third party;

(f) the methods and parameters to be used when assessing the
capital requirement for operational risk set out in Article 106, including the percentage referred to in paragraph 3 of Article 106;

(fa) the methods and adjustments to be used to reflect the reduced scope for risk diversification of insurers related to ring-fenced funds;

(g) the method to be used when calculating the adjustment for the loss-absorbing capacity of technical provisions, as laid down in Article 107;

(h) the subset of standard parameters in the life, non-life and health underwriting risk modules that may be replaced by undertaking-specific parameters as set out in Article 104(7);

(i) the standardised methods to be used by the insurance or reinsurance undertaking to calculate the undertaking-specific parameters referred to in point (h), and any criteria with respect to the completeness, accuracy, and appropriateness of the data used that must be met before supervisory approval is given;

(j) the simplified calculations provided for specific sub-modules and risk modules, as well as the criteria that insurance and reinsurance undertakings, including captive insurance and reinsurance undertakings, shall be required to meet in order to be entitled to use each of these simplifications, as set out in Article 108;

(ja) the approach to be used with respect to related undertakings within the meaning of Article 210 in the calculation of the Solvency Capital Requirement, in particular the calculation of the equity risk sub-module referred to in Article 105(5), taking into account the likely reduction in the volatility of the value of those related undertakings arising from the strategic nature of those investments and the influence exercised by the participating undertaking on those related undertakings.

Those measures designed to amend non-essential elements of this Directive, by supplementing it, shall be adopted in accordance with the regulatory procedure with scrutiny referred to in Article 304(3).

2. The Commission may adopt implementing measures laying down quantitative limits and asset eligibility criteria in order to address risks which are not adequately covered by a sub-module. Such implementing measures shall apply to assets covering technical provisions, excluding assets held in respect of life insurance contracts where the investment risk is borne by the policyholders. Those measures shall be reviewed by the Commission in the light of developments in the standard formula and financial markets.


        Article 110
General provisions for the approval of full and partial internal models


1. Member States shall ensure that insurance or reinsurance undertakings may calculate the Solvency Capital Requirement using a full or partial internal model as approved by the supervisory authorities.

2. Insurance and reinsurance undertakings may use partial internal models for the calculation of one or more of the following:

(a) one or more risk modules, or sub-modules, of the Basic Solvency Capital Requirement, as set out in Articles 104 and 105;

(b) the
capital requirement for operational risk as laid down in Article 106;

(c) the adjustment referred to in Article 107.

In addition, partial modelling may be applied to the whole business of insurance and reinsurance undertakings, or only to one or more major business units.

3. In any application for approval, insurance and reinsurance undertakings shall submit, as a minimum, documentary evidence that the internal model meets the requirements set out in Articles 118 to 123.

Where the application for that approval relates to a partial internal model, the requirements set out in Articles 118 to 123 shall be adapted to take account of the limited scope of the application of the model.

4. The supervisory authorities shall decide on the application within six months from the receipt of the complete application.

5. Supervisory authorities shall give approval to the application only if they are satisfied that the systems of the insurance or reinsurance undertaking for identifying, measuring, monitoring, managing and reporting risk are adequate and in particular, that the internal model complies with the requirements referred to in paragraph 3.

6. Any decision by the supervisory authorities to reject the application for the use of an internal model shall be accompanied by the reasons therefore.

7. After having received approval from supervisory authorities to use an internal model, insurance and reinsurance undertakings may, by a decision stating the reasons, be required to provide supervisory authorities with an estimate of the Solvency Capital Requirement determined in accordance with the standard formula, as set out in Subsection 2.


        Article 123
Documentation standards

        Insurance and reinsurance undertakings shall document the design and operational details of their internal model.

The documentation shall demonstrate compliance with Articles 118 to 122.

The documentation shall provide a detailed outline of the theory, assumptions, and mathematical and empirical basis underlying the internal model.

The documentation shall indicate any circumstances under which the internal model does not work effectively.

Insurance and reinsurance undertakings shall document all major changes to their internal model, as set out in Article 113.
 

             
 
Solvency ii and Operational Risk
Fourth Quantitative Impact Study: Operational risk questionnaire

a) Does your operational risk management system capture the operational risk events and near misses in day-to-day management in practice?

b) Does your operational risk management system capture the interrelations between the various risks identified?

c) "Does your undertaking quantify and keep a record of the operational risk events and near misses(1)(2) that have occurred?

(1) A near miss is a risk event that has occurred but has not resulted in a loss.

(2) For near misses quantify the potential loss – if possible."

d) What are the methods used to quantify the operational risk events and near misses that have occurred?

e) Does your undertaking categorise the operational risk events and near misses?
If yes, in what categories?

f) What methods do you use to quantify operational risk, both in respect of the size of possible events and their likelihood?

g) How far back do the records go on operational risk events that have occurred?

h) How far back do the records go on near misses that have occurred?

"Irrespective of whether an operational risk framework is in place, all (re)insurance undertakings do have operational risk information in various departments. Please answer the following questions regarding the operational risk events and near misses that have occurred in the last five years."

i) How many operational risk events and near misses has your undertaking registered?

j) Describe them, explain what kind of mitigation techniques were in place at the time of the event, and quantify their impact.

k) Has your undertaking introduced new mitigation techniques after analysing the above described events? Which ones?

In case participants do not have an individual categorisation, the following categories may be used in describing these events, unless participants decide on other levels of categorisation more specific to insurance; in this case, participants should provide the whole range of categories used, even if no information has been gathered regarding some of them.

Categorisation of Operational risk events based on the categories proposed by The Operational Risk Insurance Consortium (ORIC):

- Intentional misconduct (internal fraud);

- Unauthorised activities by external parties (external fraud);

- Employment practices and workplace safety;

- Clients, product and business practices;

- External events that cause damage to physical assets;

- Business disruption and system failures;

- Business process risks.

In case participants have not quantified the impact of their operational risk events, they should use the following classes:

- No effect;

- Negligible effect;

- Negative effect but no major impact on the day-to-day business;

- Negative effect and potential major impact on the day-to-day business;

- Negative effect and major impact on the day-to-day business.

l) Taking into account all aspects of your operational risk management system including any mitigation techniques employed, do you think the operational risk capital charge of the standard formula, as calculated in QIS4, is appropriately designed and calibrated? If not, why?
 
             

Read more about:

Solvency ii and Operational Risk: Fourth Quantitative Impact Study

Consultation Paper No. 53. Draft CEIOPS’ Advice for Level 2 Implementing Measures on Solvency II:
Article 109 1 (g) SCR standard formula - Operational Risk


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