Reducing risk through insurance

In this article, Silke Brandts describes a general algorithm for quantifying the risk-mitigating impact of operational risk insurance. She then presents a simple haircut approach to incorporate residual risks inherent in the insurance contracts into the model and confronts it with an approach based on a stochastic model. Finally, she shows that the haircut approach may significantly underestimate the occurrence of loss clusters and tail events

Insurance against operational risk losses is widely used by financial institutions and can present a powerful risk-mitigating instrument by changing the gross loss distribution. The impact of insurance on regulatory capital, however, is subject to a series of qualitative and methodological requirements set out by the regulators. These requirements can be separated into (1) formal requirements concerning the insurance provider and the contract, and (2) the treatment of residual risks inherent in