One of the significant methods for measuring the effectiveness of banks in managing their operational risks is the evaluation of the losses. In evaluating levels of loss several factors should be kept in mind:

Recurring Vs Catastrophic Losses - In general, routine recurring losses (small teller frauds, thefts of cash from ATMs, low value check forgery, etc.) should not exceed the banks deductible level. Although, all banks should attempt to control and reduce these losses to the lowest practical level, some losses must be expected as a cost of doing business. In fact, implementing a true "zero loss" environment would probably be far more costly than simply observing an acceptable level of small losses. Insurance should be viewed as catastrophe cover and should only be used to assist the institution in dealing with the consequences of "low probability and high cost" risks. Again, insurance should not be used as a substitute for sound and effective management of operational risks.

Frequency, of Claims Payment - If deductible levels have been established properly underwriters expect to pay a loss on an account every 7 to 10 years. However, with a loss frequency of more than 1 per 5 years indicates both a deductible level which is too low and problems with the bank's internal controls

Allocation of Losses

In an organisation, such as a bank which consists of many different departments and subsidiaries. it is good risk management to charge a unit directly for its losses However, it may be very difficult for smaller units to handle their self-insurance as self-insurance levels may be handled more easily by large units or subsidiaries. Therefore, in order that all units be allocated their fair share of premiums and loss costs, it is often necessary to establish an internal pooling or loss allocation system. Banks may add to the credibility and create accurate allocating systems by using acturial methodology and techniques. Such a system allows for the direct allocation of loss in some cases and the sharing of loss in others. This can make a system of higher deductibles practical.

For example, consider a bank with fifty branches and other non bank subsidiaries. A SR 5 million loss spread among the fifty units in one time period would amount to SR 0.1 million on the average. If an appropriate deductible is charged to the unit that actually suffered the loss and loss-sharing levels of the other units are adjusted relative to their size, a relatively large loss may be absorbed relatively painless. Further, very large losses could be amortized over a period of years. However, there are two important issues to consider in constructing such a system.

Penalize Frequency; Accommodate Severity -Allocation system should penalize frequency and be more forgiving of severity. This is based on the fact that severe or the high cost low probability risks" are far more difficult to control than incidents which to occur frequently and that if many incidents are allowed to occur frequently, it is inevitable that one or more will be severe. For this reason, charging units directly for loss costs can significantly improve loss controls, but the size of the penalty should be appropriate to the size of the operation.

The System Must be Accurate and Understandable - Allocation systems must be both accurate and clearly understandable to unit managers. Many allocation systems have failed because they became very complex in an attempt to create a degree of accuracy that may serve no useful purpose. The following example may serve to illustrate the point:

In this bank, a deductible of SR 1 million is set for Head Office and other wholesale nondepository subsidiaries (i.e trust company, the private bank, etc) while deductible as low as SR 50,000 are set for the small branches - a total of 35 units. Each unit pays 100% of its deductible for losses occurring in its units, and 50% of the loss in excess of the deductible up to an amount no greater than 150% of the stated deductible amount. Thus, a unit with a SR 50.000 deductable would pay the first SR 50,000 of the loss plus 25,000 of the next 50,000 loss for a total possible deductible of Sr 75,000. All units then share equally an excess losses up to the institution's aggregate of SR 1,000,000 deductible. Therefore, the largest loss which could be shared is SR 925,000 which when divided by 35 units is SR 26,428 per unit. If this is still too large a burden for the smaller units, the risk sharing percentages may be adjusted or a cap set on the maximum loss to be borne by smaller units, with the remainder shared corporate-wide.