Operational risk measurement and management

Guoqiang Li

8.1 INTRODUCTION

In a regulatory framework such as the Basel Capital Accords for banks or Solvency II for the European insurance industry, operational risk is defined as the risk of loss or other adverse consequences from inadequate or failed internal processes, people or systems or from external events. This definition includes the risk of legal liability but excludes strategic risk, business risk (such as the risk of loss from changes in the business environment) and reputational risk. This definition of operational risk has been widely adopted in the enterprise risk management framework of banks, insurers and companies in other sectors (CRO Forum 2014).

Operational risk has unique features that differentiate it from other risk categories. First, an insurer takes insurance, credit or market risks to make profits, where higher risk is usually associated with a higher expected return. For these risk categories there is often a risk–return trade-off analysis or risk appetite principle. For example, the hedging of equity risk in variable annuities not only reduces the risk but also reduces the net income due to the hedging cost. Similarly, the purchase of catastrophe risk reinsurance