3.1 Self Insurance
The financing of operational risk is based upon the premise that any organization of a certain size will pay for its operational losses either by purchasing insurance or by totally self-insuring. Eventually insurance costs will adjust to pay for actual incurred losses. There is a clear and direct relationship between insurance premiums and actual losses which may be tracked over a period of time (generally three to ten years). Consequently, some organizations decide to underwrite the risk themselves by not insuring with external parties. The exception to this theory is the random catastrophic loss (or "long tailed risk") which occurs rarely, if ever. Even in self insured programs, insurance is purchased or should be purchased to cover these "long tailed risks" The retention of risk is most appropriate for low cost/high frequency losses. Some unsophisticated buyers purchase insurance only for smaller losses. This is both an extremely uneconomical method of financing small losses and exposes the organization to potentially catastrophic losses. Once management realizes that the organisation will ultimately pay for its own losses, risk identification and risk control will become paramount in managing risk.
Even in "insured" programs there is a strong element of self insurance. This becomes more predominant for those risks whose costs becomes higher as the size of the organization increases i.e. where insurance cover is generally reserved for catastrophic risks. Therefore, as the nature and the size of banks within the Kingdom changes, so too does the need to address the issue of self insurance.
Self insurance has three major advantages:
- Improved loss control as a result of increased risk awareness.
- Improved claims control.
- Cash flow benefits.
However, it also has two significant disadvantages:
- Financial instability in cases of poor budgeting/reserving.
- A need for increased management oversight and administration.
There are various forms of self insurance as given below:
3.1.1 Through Contracts
A bank may transfer its financial responsibility through purchase of insurance or it may transfer its liability through a contractual arrangement (hold harmless agreement).
Self insurance may be obtained through a contractual agreement. As a practical matter, the ability to transfer risk contractually depends on whether one party or the other to the contract is in a better bargaining position. As one cannot always arrange to have a contract drawn in one's favour, there should be a review of all contracts before they are signed to make sure what liabilities are being accepted.
Even when the bank is in the position of being able to dictate terms of contract, every effort should be made to ensure that the provisions for the transfer of risk are both reasonable and equitable to both parties. In recent years, many countries have enacted legislation which has acted to significantly restrict the use of "hold harmless" language in contracts. When transferring risk through any form of hold-harmless agreement, it is essential that a number of points be reviewed by competent legal counsel:
Reasonable of Provisions - Harsh and restrictive language may serve to both antagonize customers .and may be invalidated in court as being contrary to both law end public policy. 1t is essential that the bank clearly understand precisely what contractual limitations of liability are legally acceptable in the jurisdiction in which the contract is to be enforced.
Clarity of Language - Unclear or ambiguous language will usually be construed against the maker of the contract. Therefore, it is critical that all contracts be written clearly and that unnecessary legal 'jargon' is avoided since much of the traditional legal language has been invalidated by recent changes in statute in many countries.
Disclosure of Obligations - All contracts should clearly disclose the obligations of all parties to the contract. Failure to adequately disclose obligations may make the contract un-enforceable.
Financial Soundness - The bank should always ensure that the counter-parties are financially to meet their contractual commitments. It is often useful to obtain an irrevocable financial guarantee from the counter-party
3.1.2 Unfunded Retention
The most common method of unfunded retention is the deductible. Also refer to section 3.2.3 entitled Deductible. Generally deductibles should be used to eliminate coverage for losses that are apt to occur regularly. For example deductible levels of employee dishonesty should be sufficiently high to eliminate low level theft of cash by Tellers and ATM Machines.
3.1.3 Funded Retention
Although more rare than unfunded programs, self insurance also includes programs where funds are actually set aside to pay incurred losses These have several significant benefits including the following:
1. Liability Accounting - By using a funded approach, the funding process goes hand in hand with an accounting system which establishes the amount of the liabilities. It is extremely useful to have an accurate measurement of year-by-year costs of operational losses - particularly as these risks grow relative to the bank’s size. This assessment ensures that significant unfunded and unrecognized liabilities are not accumulating under the self-insurance program. Furthermore, it is crucial that actuarial analysis is used for projecting losses and in determining loss reserves to avoid significant unfunded or unrecognized liabilities.
2. Service and Product Pricing - An accurate accounting and assessment of costs associated with operational losses can be important in both pricing the institution's products and services and in determining those business areas which are profitable and those which are not.
3. Investment of Funds - A funded program allows specific investment income to be earned on the funds comprising the funded loss pool. This, in turn, offsets the cost of the losses themselves.
3.1.4 Setting up own Insurance Companies
When a banks actually establishes its own insurance company it is also called "single parent captive". Such insurance companies actually act as a re-insurers, using the services of a licensed insurance company to issue policies and handle claims. This licensed insurance company is often referred to as the "fronting" insurer. Under this arrangement, the fronting insurer does the insurer's claims handling and loss control services, satisfies various legal and regulatory requirements concerning policy issuance, and may also satisfy creditors shareholders, regulators, and other interested parties The "fronting" insurance company actually assumes the primary legal obligation for the payment of claims. Thus, if professional indemnity is insured in the captive but the bank becomes insolvent, the "fronting" insurer issuing the professional Indemnity Policy is ultimately responsible for the payment of all incurred claims, regardless of whether it is able to collect from the captive or the bank. Therefore, while the use of single parent captives may provide a potentially viable vehicle for managing operational risk within a single bank, its use must be carefully evaluated in relation to legal implications within the Kingdom.