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

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Q. Conversely, you are an insurance firm which is attempting to persuade the regulator to allow it to use an internal model and you would like to be able to incorporate a significant diversification offset between operational risk and other elements of the SCR. What arguments might you propose to justify your position?

Essentially, your line of reasoning would need to be one that came up with the opposite conclusion to that set out in the answer to A.8.1(a). This might involve attempting to reason as follows:

         i.            Different risks do not all in practice hit at the same time. Most business failures involve a complex interplay of factors, and although operational risk failings are a common contributory factor they are often poorly correlated with other types of risk present in the SCR computation.

       ii.            A regulatory framework that makes overly cautious assumptions about correlations between different risk factors is likely to be overly prudent. This would discourage use of efficient business structures and could lead to excessive capital charges, both of which may result in businesses exiting the market and ultimately probable delivery of poorer value-for-money to end customers.

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