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The Actuary The magazine of the Institute & Faculty of Actuaries

IFoA sets out best practice for operational risk models

The Institute and Faculty of Actuaries (IFoA) has outlined measures to address the issues of operational risk for banks, insurers and other financial services firms.


A computer on fire © iStock
Companies are exposed to a range of operational risks such as loss of data. © iStock

According to its report Good practice guide to setting inputs for operational risk models, scenario analysis was essential in order to properly model operational risks such as loss of data.

Expert judgment was also necessary to determine correlation assumptions given the limitations of correlations derived from historic data. 

However, the report warned reliance on scenario analysis and expert judgments would create “significant subjectivity” for operational risk models. “This needs to be controlled by robust and independent review and challenge”. 

It added preparation was crucial for scenario analysis. This involves identifying key experts, ensuring they were properly briefed on requirements, and providing supporting information to help them with the scenario assessment.

During the assessment process scenario analysis could be conducted in a number of methods, such as a series of interviews or workshops with experts. “Whichever approach is adopted, a key challenge is to avoid biases,” the document revealed. 

Additionally, any points raised during assessment need to be captured and documented. This should include not just the scenarios ultimately chosen but also those considered but rejected. 

“This can help demonstrate to regulators the breadth of coverage of the scenario analysis exercise,” it confirmed.

Patrick Kelliher, chair of the IFoA Operational Risk Working Party, said: “From pensions and PPI mis-selling to LIBOR rigging, financial firms have suffered billions of pounds of losses from operational risk events. 

“It is important that banks, insurers and other financial firms understand the extent of their exposure to operational risk.”