Banking Risk to Insurance Risk What can go wrong

1
Banking Risk to Insurance RiskWhat can go wrong?

• David W. Clark
• January 28, 2004
• Lecture to
  The Insurance Institute of London

2
What is the underlying theme?

• Financial market exposure to types of risk
• Credit, market, operational and other
• The transfer of risk and risk products between
  different types of financial institutions
• The amount of capital that supports risk taking
• Regulatory approach to capital and risk
• Wider interests of consumers and stakeholders,
  risk in society and governance

3
What has happened to banks?

• Evolving sophistication of credit and market risk
  management since the 70s
• Manifest in identification, measurement,
  reporting and management
• Impact of major macro economic and political
  events
• Bretton Woods, oil wars, inflation, recession
• Cold war, the collapse of communism
• Bursting bubbles

4
Banks and Basel

• Basel 1, 1988 the benchmark accord
• 8 capital ratio
• Tier 1 and Tier 2 capital
• Most banks hold above the minimum
• Evolving agreement on best practices
• Basel 1 was not just a regulators project
• Above all about the alignment of risk and capital
• 8 ratio was not tested in the same way as Basel
  2 metrics

5
Banks and Basel

• Lead to major changes in approach to risk
  management
• Control of risk weighted assets
• Focus on return on capital
• Development of risk control units and Middle
  Offices
• Transparency in reporting
• Roles and responsibilities of senior management
• Quantitative approach to modelling risk capital
• Basel 2 is a response to risk refinement
• (N.B. There is no insurance Basel)

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Golden Oldies(and those not so old)

• Bankhaus I.D. Herstatt
• Maxwell
• Polly Peck
• Continental Illinois
• Crocker National
• ENRON

• Barings
• UBS
• Nat West
• AllFirst
• NAB
• Parmelat

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What Basel 2 is trying to achieve

• Pillar 1 (capital charge) Pillar 2 (supervisory
  review) Pillar 3 (transparency)
• Promises incentives and no overall increase in
  the amount of capital in the system
• Refines the metrics for credit risk measurement
  (IRB)
• Introduces a capital charge for Operational Risk
  (OR)
• Supervisory review allows supervisors to change
  capital ratios
• Where ARROW fits in

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ARROWThe Regulatory Product

• A successor to RATE (Risk Assessment and Tools of
  Evaluation)
• Evolved from the Barings report
• Risk Based Supervision the new approach
• ARROW brings it into line with the FSAs
  statutory objectives (N.B. - RTOs)
• Scores impact and probability between high
  and low
• Applies to all financial institutions, not just
  banks

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The Regulatory Product

• Understanding the business
• Identification of potential problems and risk
  mitigation
• Agreement/understanding with the firm
• Assessment of capital ratios
• ARROW letter sent to senior management
• Detailed and complex for supervisory teams
• (is it over engineered?)
• Supervisors need a good working knowledge of the
  firm and relationship with the people

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GovernanceResponsibilities of the Board(in
respect of Risk Management)

• External
• Shareholders
• Regulators
• Auditors
• Market place (clients, competitors, rating
  agencies)

• Internal
• Participation with executive and staff
• Sponsor RM and demonstrate awareness
• Understand and challenge RM methodology

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Banking/Insurance Boundaries

• Credit Derivatives
• Arbitrage between capital regimes
• Standards of documentation
• Intent of product structure (investment or
  insurance)
• Repackaging to retail buyers
• Operational Risk
• Basel excludes reputation and strategic risk in
  OR
• Insurance as an OR mitigant
• Long term products and risk measurement

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So, what can go wrong?

• Difficulties of getting international agreement
  on insurance regulation
• Inadequate consultation with the industry
• A higher capital requirement seems to be on its
  way
• Are the risk categories right?
• Are the metrics and ratios right
• Competitiveness and the position of London
• Making sure that ENOUGH risk is taken