Is the standard approach under the SAM regime...

In fact one may go as far as saying that the focus, from a short term insurance perspective, has been limited to underwriting risk. It is therefore unsurprising that Solvency II and hence SAM aims to address this shortcoming by imposing a capital charge, albeit an onerous one, on insurers for "the risk of loss arising from inadequate or failed internal processes, or from personnel and systems, or from external events." Insurers will also need to demonstrate the management of operational risk as part of the Own Risk and Solvency Assessment (ORSA).

To underscore the significance of the operational risk capital charge, early indications are that under its current form, non-life insurers may hold 10-15% of their solvency capital requirement in respect of operational risk. Considering that the industry's capital requirement is around R26bn, this implies that about R3bn is attributable to this crudely estimated item.

Under SAM, the only drivers of the capital charge for operational risk are premium volume and technical provisions. Both have been shown to be further along the queue of differentiating features of an insurer having low or high risk of operational losses. In particular, the control environment is intuitively more noteworthy and has been empirically demonstrated to impact the loss distribution of operational events.

Furthermore, operational risk differs significantly by functional area, with for example selling practices and distribution strategy a key discriminate. So, the question which any short term insurer can rightfully pursue is, why is the standard approach to operational risk under SAM (which is assumingly calibrated to an average European life and non-life insurer), suitable to them?

To take this a bit further, the standard approach levies up to 30% of the Basic Solvency Capital Requirement (essentially the diversified capital required on the remaining risks considered in the regime as well the charge on intangible assets) as cover for operational risk. Where your organisation (irrespective of products sold) is to grow its annual earned premiums in excess of 10%, 3% of that excess is required to be set aside as capital.

Compounding this disincentive is a flat charge of 3% on the technical provisions which is difficult to logically reconcile to operational risk. Furthermore, the assessment is performed on a gross basis and therefore no relief is available from reinsurance or other risk mitigation strategies.

Feedback provided by EIOPA (the European insurance regulator) on the various Solvency II quantitative impact studies suggested that relying on the standard approach for the assessment of operational risk, although attempted by several undertakings, would be considered a deal breaker if pursuing an internal The challenges of pursuing an internal model approach are significant especially in the context of operational risk, where it is unlikely that your organisation has gathered sufficient quantity and quality data across it various business functions. However, even those insurers that chose to apply the standard approach to determining this capital charge are likely to face challenges in terms of demonstrating, under the ORSA, it's appropriateness for their organisation. Simply put, the choice between using an internal model approach or the standard formula is no easy task.

It is expected that SA QIS 2 will address some of the concerns regarding the calibration of the Non-Life insurance risk components of the SCR. Does this then provide an opportunity for your organisation to pay more attention to the penal charge levied under the SCR for operational risk?

*This article was written by Jonathan Haveman - PwC and appeared in the SAIA Bulletin, April 2012.