Extreme Events – Specimen Answer A.8.1(a)
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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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