Solvency II: The Capital Challenge of Operational Risk
As Solvency II beds down as part of insurers’ daily business, many are looking to extend their internal model to include operational risk. Given the conservative assumptions built into the Standard Formula, operational risk can account for a sizeable proportion of an insurer’s Solvency Capital Requirement (SCR). Insurers may therefore wish to build an Internal Model for operational risk, which more accurately reflects their own view of their organisation’s risk profile, and which supports the effective management of that risk.
However, the identification, quantification, and mitigation of operational risk can present a substantial challenge under Internal Model approaches.
The use of an Internal Model for operational risk gives a firm a range of potential benefits, with a clear link between risk assessment and quantification, and risk mitigation and management. However, regulators have been critical of operational risk models in the past, and are only now beginning to outline their own expectations of model outputs. Before accepting the validity of either the model or of any mitigation claimed, it seems likely that regulators will expect a robust exploration, not only of overall operational risk.