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Extreme Events – Specimen Answer A.8.1(a) – Answer/Hints

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Q. You are an EU insurance regulator who does not wish to rely merely on the wording of the Directive to justify no diversification offset between operational risk and other types of risk. What other arguments might you propose for such an approach?

 

Three possible lines of argument are:

 

         i.            The correct level at which to set regulatory capital depends heavily on the magnitude and drivers of relatively extreme events. Different risk factors tend to be more correlated in such circumstances (relative to their behaviour under more usual outcomes). Adopting a high correlation in such a computation implicitly recognises the lack of risk diversification that typically applies in such circumstances.

 

       ii.            A more sophisticated variant of (i) might observe that the key statistic that ought ideally to be most focused on in regulatory solvency computations (as far as the regulator is concerned) is Expected Shortfall. This metric is typically even more tail dependent than Value-at-Risk, the metric most commonly used in regulatory computations at present. Moreover, if essentially all cases where Expected Shortfall is large include an operational risk failure then the relevant Expected Shortfalls may be approximately additive, even if the actual tail dependency takes a more complex form.

 

      iii.            A very prudent approach to incorporating operational risk may increase the incentives on firms to minimise this type of risk. This may be considered desirable by regulators either because they in general think that such risks are underemphasised by firms or because they think that it is particularly desirable to incentivise firms to tackle these risks. Some types of risk can be expected to be compensated for by additional reward, but this is arguably less likely to be the case with operational risks, which are often asymmetric and very largely only downside orientated. Mitigating operational risk, if it is not too expensive, may therefore be viewed as close to providing firms with the opportunity to benefit from a ‘free lunch’.

 


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