Operational Risk Capital
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1 Operational Risk Capital Considerations for a Conglomerate Martin Lalor Suncorp This presentation has been prepared for the Actuaries Institute 2013 Risk and Regulation Seminar. The Institute Council wishes it to be understood that opinions put forward herein are not necessarily those of the Institute and the Council is not responsible for those opinions.
2 Operational Risk Capital Considerations for a Conglomerate Agenda 1. Suncorp Corporate Structure Internal RBC modelling framework 2. Operational Risk Regulatory capital assessment for a Conglomerate Internal RBC assessment at Suncorp
3 Suncorp Corporate Structure We have a fascinating challenge for: 1. Regulatory capital modelling across all of our entities 2. Robust & consistent internal RBC modelling across all of our entities 3. Robust & consistent operational risk modelling across all of our entities
4 Suncorp s 1 st Generation Internal RBC 1. Scenario driven approach, accounting for: Insurance risk Credit risk Market Risk ALM Risk Operational Risk 2. Applied consistently within a distinct RBC model for each Business Unit 3. Projecting NPAT and Balance Sheet (inc. regulatory capital) for each scenario 4. Aggregation of scenario outputs from each Business Unit A key challenge is to ensure consistency across RBC models, while Business Units maintain ownership and independence
5 Operational Risk Capital Considerations for a Conglomerate Agenda 1. Suncorp Corporate Structure Internal RBC modelling framework 2. Operational Risk Regulatory capital assessment for a Conglomerate Internal RBC assessment at Suncorp
6 Regulatory Capital for Operational Risk Industry APRA Standard Comment ADI Standardised APS 114 ORRC = capital charge which is proportional to business size ADI Advanced APS 115 Advanced Measurement Approach (AMA), with key principles: Loss distribution approach Drawing on ILD (internal loss data) & Drawing on ELD (external loss data) Drawing on scenario workshop assessments Drawing on BEICFs Business Environment and Internal Control Factors General Insurance Standard General Insurance Internal Model Based GPS 118 GPS 113 ORC = capital charge which is proportional to business size/growth Paragraph 21 Operational risk module must consider: Relevant internal event data Relevant external event data Scenario Analysis BEICFs Life Insurance LPS 118 ORC = capital charge which is proportional to business size/growth (Risk, investment linked, and other business) RSE SPS 114 SPG 114 Conglomerate Standards Non-APRA Regulated 3PS 110 (Draft) Operational Risk Financial Requirement (ORFR) An RSE must determine a target amount of financial resources to address operational risks of the RSE licensee s operations APRA does not endorse any particular approach for determining ORFR target APRA expects ORFR is equal at least to 0.25% x FUM Paragraph 50, capital allocation must be:..based on rigorous and robust methodology In many of these entities, the only material financial risk is Operational Risk The basic methodology is reasonably well aligned. Good scope for more advanced approaches.
7 Regulatory Capital for Operational Risk ORFR ORCOA 1 ORCO ORRC Conglomerate Capital is the sum of: ORCNI ORCR ORCI But what a head spin! 1 Suncorp defined term
8 Operational Risk Capital Considerations for a Conglomerate Agenda 1. Suncorp Corporate Structure Internal RBC modelling framework 2. Operational Risk Regulatory capital assessment for a Conglomerate Internal RBC assessment at Suncorp
9 Suncorp s 1 st Generation Internal RBC 1. Scenario driven approach, accounting for: Insurance risk Credit risk Market Risk ALM Risk Operational Risk 2. Applied consistently within a distinct RBC model for each Business Unit 3. Projecting NPAT and Balance Sheet (inc. regulatory capital) for each scenario 4. Aggregation of scenario outputs from each Business Unit Shifting focus to operational risk, and Suncorp s key principles
10 Suncorp Internal Approach to Operational Risk Principle Comment Pragmatic A relatively simple 1 st generation LDA modelling approach across Suncorp With separate frequency and severity distributions for each Event Type Stochastic sampling Integrated Within the broader internal RBC model for each Business Unit Consistent A consistent methodology for each Business Unit across the Group Common definition of Event Types The Basel II (APRA) definition 7 x Category 1 Event Types Intuitive Linking operational risk capital assessment to relevant risk indicators/drivers, and not just linking to the size and growth of business alone Calibration of LDA with the use of: ILD ELD Scenario workshops BEICFs Effectively at Suncorp, we have implemented simple AMAs, independently but consistently within each of our Business Units.
11 Suncorp Internal Approach to Operational Risk Stochastic Sampling
12 Suncorp Internal Approach to Operational Risk A 7 x 5 Matrix of Cells for modelling purposes Suncorp Business Unit Basel II Event Types General Insurance Life Bank Other Entities Enterprise Wide Internal Fraud External Fraud Employment Practices and Workplace Safety Clients, Products, & Business Practice LDA approach adopted for each Cell Damage to Physical Assets Business Disruption & Systems Failures Execution, Delivery, & Process Management
13 Loss Distributions Observed Range of Practice (for Banks) Basel Committee on Banking Supervision Participants Severity versus Frequency Observed Range of practice in key elements of Advanced Measurement Approaches July participating AMA banks (including 5 Australian) The vast majority of banks model severity and frequency distributions separately Frequency Distributions 93% use a Poisson distribution 20% use a Negative Binomial Severity Distributions 33% use LogNormal 17% use Weibull Others are Generalised Pareto, Gamma, Generalised Beta Although 4-years old, still insightful.
14 Suncorp Internal Approach to Operational Risk Correlation: The many dimensions to consider. But how material is each? What empirical evidence exists? Correlation Dimension Which Event Types Which distribution Description One Event Type with another, e.g.: External Fraud with Clients, Products and Business Practices Should it be modelled as correlation between: Frequency distributions Severity distributions Body or Tail? Annual Loss distributions Or perhaps the joint behaviour of certain loss events should be driven by an underlying causal driver Across Business Units Between Risk Types Are operational risk losses in one Business Unit related to those in another? For example: Is operational risk and insurance risk in General Insurance business correlated? Is operational risk and credit risk in the Bank correlated?
15 Suncorp Internal Approach to Operational Risk Some other considerations: Consideration Separate Severity Distributions Comment It may be appropriate to model separate distributions for an event type: High frequency, low severity events (HFLS) Low frequency, high severity events (LFHS) Calibration of LDA It may be appropriate to calibrate using different inputs for different parts: ILD more useful for HFLS Scenario workshops and ELD more useful for LFHS Double Counting For example: External Fraud (claims) in General Insurance: Could be included within both Insurance risk and Operational risk Appropriateness of ELD Need to consider carefully the relevance/applicability of external loss databases: Scaling: Accounting for the relative size of the contributing organisation versus your organisation Filtering: Accounting for the relevant business lines in your organisation versus the data An important consideration: How to drive change in risk practice, if staff are unable to influence the ultimate capital assessment?
16 To Sum Up 1 st generation internal modelling solution in place A key challenge: Was to ensure consistency across Business Unit RBC models, although they maintain ownership and significant independence of decision making Many considerations on the path to a 2 nd generation
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