Philippe Velard Finmedia Conference, Bucharest Basel II – Operational Risk How insurance will play February 22, 2006

2 Marsh 1.The relationship between operational risk and insurance 2.Basel II Requirements 3.Main areas of forthcoming challenges for insurance management inside the bank Agenda

3 Marsh Marsh/FINPRO Insurance and other risk transfer transactional services Mercer Oliver Wyman Advisory and consultative services Marsh Risk Consulting Specialized support in related areas such as STARS, business continuity planning and crisis consulting MMC Center of Excellence for Operational Risk Expertise in strategy, actuarial and risk consulting to the financial services industry Pioneered integrated risk management frameworks based on systematic risk quantification World leader in insurance services Full range of services to identify, value and transfer risk Knowledge of global insurance markets and capital markets risk solutions How MMC is organised on Basel II and operational risk

4 Marsh Section 1. The relationship between operational risk and insurance

5 Marsh The Capital Impact of Insurance Captive Retention Single Line Multi Line Comprehensive Cover EarningsEconomic Capital Operational Risk Distribution Alternative Risk Financing Expected loss Maximum probable loss Catastrophic loss Insurance and Alternative Cover There is significant potential to transfer operational risk through both traditional insurance and alternative risk-financing structures

6 Marsh Traditional insurance does not cover all operational risks in financial institutions, indeed it will cover selected impacts of selected risk scenarios Basel and Advanced Measurement Approaches has shown that insurance is associated with less than 30% of operational risk capital The relationship between operational risk and insurance

7 Marsh How good is the insurance coverage ? Still numerous uncovered severity operational risks Investment Bank Markets Retail Bank Commercial Bank Payments & Services Agency Services Asset Management Retail Brokerage 1 Internal Fraud 2 External Fraud 3 Human Resources 4 Clients & Markets Risk 5 Property 6 Systems Disruption 7 Process Risk Holding Crime E&O Prop. B.I.

8 Marsh Section 2. Basel II Requirements

9 Marsh Basel II requirements : insurance will reduce the regulatory capital allocated to operational risk, under specific circumstances : Limited to the advanced measurement approach (A.M.A.) Capped at 20 % of the regulatory capital before insurance Subject to a list of qualitative requirements

10 Marsh The qualitative requirements from Basel II * claims paying ability rating of A * initial term > 1 year * residual term > 90 days * notice of cancellation > 90 days * coverage provided by a third party insurer (no captives) * no exclusion linked to the failure of the insured * disclosure of the insurance program * Delay and uncertainty of payment * mismatches in the coverage of risks (likelihood and impact) * cancellation clauses and residual term of the policy COMPULSORY APPROPRIATE VALUATION OF THE INSURANCE SHOULD REFLECT :

11 Marsh The Romanian context Romanian independent banks will look for basic or standard approaches, with a view, for some of them, to apply for A.M.A. in the medium term  standard banks will have to follow the operational risk management best practices guide Romanian subsidiaries of A.M.A. foreign banks are integrated in the A.M.A. project of their mother company  They have to comply with their own group procedures

12 Marsh In both cases, Romanian banks should capitalise now on the first available results of the risk identification projects they have launched 2006 Supervisory reviews Internal loss data base Insurance deductibles and captives business plans Scenarios, risk maps, external data Extension of insurance coverage 2006/2007 Insurance and capital markets transfers FREQUENCYFREQUENCY SEVERITYSEVERITY Standard Approaches validation Capital allocation model A.M.A. validation

13 Marsh Section 3. Insurance management : main challenges on the way for compliance

14 Marsh The general conditions of the insurance policy Example of a three year process month coverage Cancellation period 12 m. simplified policy wording (compliant with the Basel II risk taxonomy) Amended cancellation clauses Specific operational risks transfered to capital markets

15 Marsh The coverage extension Example of a three year process Exclusions Coverages articulation (Crime / E&O, etc…) Investment banking Unauthorised operations Cost of correction Credit fraud Confidentiality etc…. Full comprehensive op. risk coverage Large payment systems coverage

16 Marsh The necessary interaction between risk management and insurance decision Example of a three year process Use of the loss data base to determine the deductibles Use of scenarios to choose the limits of guarantee Tailored audited risk information provided to insurers Loss data base linked warranty statement Insurance modelised and input in the capital model Fully integrated insurance decision process (associating Risk Division, Compliance, Internal Audit, ALM…)

17 Marsh Other challenges for insurance managers Risk & insurance information Systems harmonisation Claims management process Articulation risk management / captives management

18 Marsh Questions ? Philippe Velard European Operational Risk Team FINPRO Division Tel: (33) Eduard Simionescu FINPRO Romania Tel: (40)

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20 Marsh Extra slides

21 Marsh Global Study of Operational Risk Management Practice – Mercer Oliver Wyman Mercer Oliver Wyman, a leader in financial services strategy and risk management consulting, recently completed a study of operational risk management practices at financial institutions globally. The goal of the study was to assess current industry practices, understand developments in those practices, and examine firms’ current challenges and surrounding issues such as the position of rating agencies and regulators. The study included an examination of industry trends in management approaches, resources, the use of qualitative risk assessments and risk measurement techniques, business mapping and capital modelling tools, and the use of insurance in mitigating operational risk. The results presented are based upon interviews with 43 financial institutions between October 2003 and March The majority of these firms are large, internationally active banks that are subject to the guidelines for operational risk management found in the New Basel Capital Accord (‘Basel II’) and resulting regulations. The study included institutions located in the United States, Canada, United Kingdom, Europe, Australia, Japan and South Africa

22 Marsh Institutional benchmarking: status of operational risk projects Source : MOW - 1Q2004 Status of operational risk initiatives “Some well developed projects, and identified areas for potential improvement”

23 Marsh Institutional benchmarking: under-developed areas A confirmation that insurance is considered as under-developed by Operational Risk managers and is becoming one of their priorities. 50% 30% 18% KRIs InsuranceLoss data collection Credit linked risk Model Source : MOW - 1Q2004