Results of Survey by The Operational Risk Research Forum September 2003

INSURANCE AND OPERATIONAL RISK

1. What would be the practical minimum notice periods for cancellation and non-renewals? Are extended cancellation periods practical?

Where there is a cancellation period, it is usually 30-60 days, although certain classes of policy are or can be non-cancellable. Business practice is not to cancel a policy unless there is a very good reason to do so. Automatic cancellation provisions apply, of course, for non-payment of premium or fraudulent misrepresentations of underwriting information during the placement process. Whilst, in general, policies expire, there may be provision for an agreed discovery period subject to additional payable or extension subject to terms and conditions, additional premium and underwriters' agreement.

If there were to be an extended cancellation period it would have to apply to both parties. Underwriters would be unlikely to accept the option for the insured to cancel with immediate effect and underwriters being held to a long cancellation period.

The overwhelming view of respondents was that the cancellation period should be a maximum of 90 days, which would give the insured a realistic time in which to arrange alternative cover. There was a preference, though, for a shorter period of either 30 or 60 days.

The above assumes that we are dealing with cancellation at expiry of the policy. Cancellation mid-term should be on a similar basis, i.e. subject to a 90 day period and notification to regulators.

Whilst there was general agreement that alternative cover could be arranged within 90 days, one respondent raised the issue of a new insurer requiring changes to controls which could take longer than 90 days to implement. It is probable that this would be accounted for by an adjustment to premium until controls had been changed to the underwriter's satisfaction.

As regards renewal, a tacit renewal process operates in some jurisdictions. This will need to be addressed to prevent arbitrage between different territories.

2. Duration of coverage. What are your views on the present text? Is it practical? Is it likely to cause changes in the insurance market? (for example, could it lead to specific OR insurance products with longer initial time periods or could it lead to firms changing insurance products every 9 months?

Until recently, policies could be purchased for periods of up to three years. This reflected the softer market then pertaining. History has shown, however, that locking in a policy for periods greater than one year has often caused problems. Clients who were locked in when the market began to fall reneged on their commitment, often by not paying the second instalment premium; conversely, where insurers were locked in at the bottom of a soft cycle, losses caused more damage than would have otherwise happened and there is now reluctance by both the direct market and the reinsurance market to be locked in for such a long period. These points were reiterated by many respondents.

It is accepted that short-term policies could bring the risk of uncertainty and volatility, but frequent changes of insurer are not the market norm. If regulators have serious concerns on this score (a concern not shared by respondents), suggestions from respondents ranged from 15 to 24 months, with an annual cancellation and re-write clause. 18 months was seen as the most acceptable compromise, if required. Under the Lloyd's accounting system, it is permissible for 18 months to sign in to one policy year of account.

THaving said that, and acknowledging that periods longer than 12 months are possible, there was an overwhelming preference for 12 months to be the norm, which is pragmatic and reflects current market practice.

The questions (and CP3) seem to imply that coverage declines in value over time. This is not true, other than in the sense that claims may reduce cover and should therefore be reflected in a revised capital assessment. Cover is in place for the full amount for the duration of the contract, irrespective of the timing and nature of renewal. The risk transfer is unaffected. [See also response to Q5 relating to the appointment of receivers or liquidators.] The issue is, perhaps, more one of renewal risk. A number of respondents made this comment and the suggestion was made that if renewal is not agreed within 90 days of expiry, this should be reflected (presumably by some form of haircut) in the bank's assessment of its AMA charge.

3. Is there a risk that requiring the insurance providers to have minimum paying ability rating of 'A' could lead to concentration problems? Should we consider lowering the rating for insurers if there is a cut through option to an 'A' rated re-insurer who guarantees payment of claims?

The wide availability of high quality capacity is obviously fundamental to the viability of an OR market. In the current economic environment there would be a clear danger of concentration among those rated A or above. Given the apparent tendency for ratings to be downgraded rather than upgraded, it is possible that this problem could be exacerbated over time. It would also be necessary to factor this in to regulatory requirements. What happens if an insurer is down-graded during the term of the insurance contract - or in later years, given the long-tail liability nature of the OR insurance classes being covered?

Cut-through options to higher-rated reinsurers would provide protection at the front end for policies written by lower-rated direct insurers. Respondents supported this approach. However, reinsurers would then have to be persuaded to take a greater credit risk on their ceding companies and this could (would?) drive up direct reinsurance costs.

Cut-through in this way is, of course, a technique already in use in many overseas markets to overcome weaknesses in local insurance markets where they are obliged to insure for legal reasons. It has the benefit of clearly tying the insurance back to the 'global master' insurance contract and so ensuring a clear contractual relationship between the client bank, insurer and reinsurer.

Respondents raised further technical issues. First, there needs to be clarity about what is meant by 'A'. There are differences between Moody's, S&P and Bests (the specialist insurance rating agency) which need to be clarified. The ratings are also long-term rather than 12 months. This needs to be recognised.

Whilst CP3 talks of claims-paying ability, it could be argued that the capital assessment should, in part, be based on the credit quality of the insurer (i.e. financial strength in addition to claims paying rating) and that recognition should be given for the discounted present value of claims, which would itself depend on a number of factors.

4. Are there legal issues arising from having an insurance contract that has no exclusions or limitations based on regulatory actions?

It is difficult to answer this question without further clarification of "regulatory action" and in many ways it is one for lawyers to research and comment.

If the term is restricted to financial sector regulators and fines or penalties which they may impose, insurance already regularly excludes payment or reimbursement of a fine or government penalty and/or related costs. It is probably against public policy in certain jurisdictions for insurers to insure against such liabilities. Interpretation often turns on whether fines are the result of criminal action or are considered to be administrative in nature. The issue is, of course, topical given both the FSA's consultation on the subject in CP191 and the recent settlement between the SEC and certain major investment banks over the relationship between their research and corporate finance departments.

Nor could insurers give an open cheque book for any regulatory action. Market abuse, money laundering and laddering are good examples where exclusions are proper both from the insurer's and a public policy point of view.

Taking a wider view, there is a standard exclusion for punitive and exemplary damages, as well as standard 'regulatory' exclusions, such as those imposed in respect of violations of the Racketeer Influenced and Corrupt Organisation Act (1961), Securities Act (1933) as amended, the Securities Exchange Act (1934) and the Employee Retirement Income Security Act (1974) (all deriving from the US).

Respondents considered it unreasonable and impractical to ban all exclusions based on regulatory actions.

5. How is receivership and liquidation dealt with practically under insurance contracts?

The effect of receivership or liquidation is to terminate the contract at the date of appointment. This applies, inter alia, to Bankers Blanket Bonds, D&O, Professional Liability and Unauthorised Trading. This does not affect coverage for acts committed before that date which fall within the terms of the policy. Cover for 'ongoing' acts ceases. It is also normal practice for the policy to allow a period of discovery for the receiver or liquidator to lodge claims arising from acts occurring on or before the date of appointment.

A standard termination clause is attached at Appendix 1. Similar clauses may also extend termination to instances where the assured ceases to be authorised to conduct business within the regulated environment.

Appointment breaks the commercial basis of the contract. One consequence of this is that it is standard practice for liquidators to appoint a new broker. The liquidator represents different interests from the previous owners and may wish to reserve the right to act against former advisers.

6. Views on captive insurers. Should recognition be given to the capital reserves of the captive insurer?

Most respondents took the broad view that transfer to a captive represented no transfer within the consolidated group. However, a number of possible exceptions were cited:

  • where there is a cut-through arrangement to a reinsurer,

  • where the captive is adequately ring-fenced,

  • where the captive has an independent rating of A or above, which would place it on the same footing as insurers identified in Q3 above, and the insurance is placed on an arm's length basis.
  • The point was also made that a captive may well be able to "map" the operational risk profile of the bank more effectively and that it is probable that any claims will be paid more promptly. Another suggested positive is that captives can build up significant funds against a catastrophic event (using the word in its insurance sense). Finally, captives are more likely to be used as a conduit to the wider insurance market and a tool for internal risk management to create an immediacy to the cost of operational risk for business units. All of these factors support the use of captives, a mechanism which should be encouraged.

    The reference to a cut-through arrangement is because there was a belief that if the capital in the captive is to be recognised, it was important to avoid any mis-match in cover.

    The use of captives, within the Basel context, is of course, restricted to AMA banks. This raises the very good question of how partial use is to be accounted for, given that the captive may be covering risks which apply to the AMA and non-AMA parts of the bank group. However, the same presumably applies to the recognition of direct insurance, as much as to captives.

    7. No mention is made by the regulators about the speed of payment. If insurance is to be seen as a capital replacement, it must presumably be available relatively speedily. What would be reasonable in these circumstances? If the answer is 6 months or longer, which might be thought too long, what mechanisms could overcome this problem?

    It was acknowledged by respondents that speed is an issue, essentially of liquidity. Insurance, though, is a contract of indemnity in which the claimant must prove the loss. This is a fundamental principle of insurance. It can be mitigated to an extent, however, by establishing the insurer's willingness to pay through letters of credit, loan accounts etc. It could also be stipulated that payment is made a relatively short time (15 days?) after proof of loss.

    Over the past few years there have been a number of discussions about the issue and new structures which might be developed to provide both the speed of payment and extent of capacity which will be required.

    Until fairly recently, the SwissRe FIORI product offered a "liquidity feature" which allowed for immediate settlement of a claim subject to post-settlement adjustment and possible reimbursement by the policyholder. This might be acceptable, although it reverses the credit risk back to the assured and also means that insurers would have lost control of the claims process.

    Two respondents pointed to the fact that broader form policies might lead to speedier claims payment. They would, though, command higher premiums, which could therefore nullify the perceived benefit.

    Speedier claims payment would also, of course, impact insurers own liquidity requirements and so could restrict capacity.

    Finally, one respondent suggested that if there is certainty that a policy will respond in full to its limits, the act of payment might fall away in relevance if the central bank is prepared to cover a payment pending resolution of the issue.

    It was interesting to note from the Basel LDCE that the great majority of claims were agreed and settled within a 12 months time-frame. Realistic time-scales vary, though, from class to class and from case to case. It is difficult to see how a specific universal requirement can be introduced.

    8. Is the 20% haircut sufficient?

    Aon has argued in its response to CP3 that the 20% haircut, without the possibility of review, is inappropriate. They also argue that the principle of the new Accord is for self-assessment, subject to supervisory approval. There is therefore no need for an arbitrary haircut of 20%.

    Marsh has published work, in its response to CP3, based on the LDCE, which seems to indicate that a range of 20 - 40% is appropriate, so that 20% is conservative.

    Another respondent suggested that if the rating of the insurer or reinsurer is taken into account, in addition to such elements as the availability of letters of credit (see response to Q7 above), it could be perfectly legitimate to ascribe a haircut of, say, 35%. The variables which should be taken into account in arriving at the appropriate haircut are, of course, many, including policy wording, exclusions, deductibles, termination language, policy period, in addition to the above. Respondents would be pleased to discuss these further with the FSA or other regulators so that regulators have a clear idea of how the market works and the market can understand regulators' concerns and address them.

    Against these views is the assumption made by a number of respondents that the 20% cap reflects regulators' concerns at the capacity of the insurance market to accept the transfer of risk which might be encouraged by a higher figure. It was also suggested by one respondent that if the haircut were higher, there might be a need for higher deductibles (above, say, the level of 'regulatory provisioning') to avoid moral hazard.

    Certainly the capital saving net of premiums will be fairly small for many banks and so may not encourage the development of new insurance products or approaches.

    It would helpful to understand the regulators' rationale for the current figure.

    9. Other issues

    There is a theme running through a number of responses that the market will probably have to consider other mechanisms to provide the capacity which will be required, as well as the adaptation of existing and creation of new products.

    Initially, the AMA population is likely to be small, although its insurance requirements are large. However, both population and capacity needs will grow. Many in the market are disappointed that 'mitigation' will only be allowed for AMA banks. Naturally, this observation is driven by the wish of the insurance industry to write more business. There is another view, though, that as cover requirements grow within the AMA population and capacity (which is inevitably finite) comes under pressure, there may be a flight to quality (i.e. AMA banks) by insurers, so that lower tiers of insured will find coverage restricted and/or more expensive. Much depends on the market, but this seems to be a legitimate consideration.

    One final point, raised by a number of respondents is that regulators must understand the nature of the insurance contract, including the need to exclude events or actions which lack fortuity.

    There is, though, a general feeling that as banks develop their OR frameworks and processes, disclosure to insurers will improve, to the mutual benefit of both insurers and insured.

    John Thirlwell, Executive Director, Operational Risk Research Forum
    September 2003

    INSURANCE AND OPERATIONAL RISK OPERATIONAL RISK RESEARCH FORUM

    APPENDIX 1

    TERMINATION

    This Policy shall terminate immediately:

    (i) in the event of there being any change in the effective ownership or control of the first named Assured whether financial or otherwise and whether occurring by operation of law, voluntary act on the part of such Assured or by merger, purchase or sale of assets or shares or in any other way

    (ii) as to any Assured other than the first named Assured in the event of there being any change in the effective ownership or control (as set forth in (i) above) of that Assured

    unless Underwriters, after having been furnished with all relevant particulars relating to the event, have offered revised terms and conditions in writing as to the continuation of cover and such terms and conditions have been accepted by the Assured

    (iii) upon receipt by Underwriters of a written request by the Assured to terminate the Policy.

    Underwriters shall refund any unearned premium computed at pro rata if terminated on the occurrence of any of the events provided for in (i) or (ii) above.

    Underwriters shall refund any unearned premium computed at short rate if terminated at the written request of the Assured as described in (iii) above.

    (iv) upon exhaustion of the Limit of Indemnity by one or more payments made under this Policy in which event the premium is deemed to be fully earned.


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