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15 October 2015 Insurance

Dealing with disaster

Financial institutions don’t like to think about failure. But sadly, there are times when they have to—when risks that they might not have known even existed suddenly appear on the horizon.

With Solvency II now finally arriving and with companies realising that operational risk is something that they will have to look at in some detail because of the new regulatory regime, operational risk insurance is a topic of a lot of discussion.

Operational risk can be defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

Operational risk covers a wide range of areas,” Angelos Deftereos, senior underwriter, operational risks at XL Catlin tells Intelligent Insurer. “Fraud, mis-selling, conduct risk, employment practices – it can be an umbrella term for a wide range of problems and misconduct. Sometimes it be as simple as the wrong people doing the wrong thing at the wrong time."

“The regulators are well aware of operational risk and the cost of not addressing this. Sometimes there can be massive losses, such as when Barings Bank collapsed in 1995 because of unreported losses on the part of Nick Leeson.

“The loss of a financial institution can be very destabilising. There’s therefore a requirement to have a risk management framework in place.”

The risks inside

The spectacular failure of Barings Bank is an excellent example of operational risk. Leeson, then the head derivatives trader in Singapore, was supposed to be a safe pair of hands in a new and speculative area of trading for the bank.

However, due to a string of failures in internal management Leeson was able to hide the fact that he was making massive losses in derivative dealings, to the point where his eventual losses of £827 million ($1.27 billion) were enough to bankrupt one of the oldest banks in the world.

Similarly, in January 2008 French bank Société Générale lost €4.9 billion ($5.5 billion) after trader Jérôme Kerviel made a series of fraudulent transactions that remain deeply controversial due to accusations that higher management did indeed know about them.

According to Deftereos, focusing on major tail risks, operational risk insurance represents a completely new business for the insurance industry, complementing rather than displacing existing programmes. Transforming insurance into part of clients’ capital structure, operational risk insurance attracts new stakeholders to the insurance-buying decision, turning chief risk officers and their colleagues from the finance team into potential insurance buyers.

In addition, Deftereos says, these business leaders are motivated by a new perspective on the insurance-purchasing decision. In addition to the risk management dimension, they are also driven by the need to implement the most efficient capital structure possible to support their business and drive down costs.

They also recognise insurance as a uniquely valuable form of capital that is both tax-efficient and which, in contrast to raising capital by issuing equity, avoids the consequences of diluting existing shareholdings.

When considering operational risk insurance these clients have three key objectives in mind:

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