The Management of Operational Risk Through Appropriate Insurance Schemes

Through Contracts A bank may transfer its financial responsibility through purchase of insurance or it may transfer its liability through a contractual arrangement (hold harmless agreement). Self insurance may be obtained through a contractual agreement. As a practical matter, the ability to transfer risk contractually depends on whether one party or the other to the contract is in a better bargaining position. As one cannot always arrange to have a contract drawn in one's favour, there should be a review of all contracts before they are signed to make sure what liabilities are being accepted. Even when the bank is in the position of being able to dictate terms of contract, every effort should be made to ensure that the provisions for the transfer of risk are both reasonable and equitable to both parties. In recent years, many countries have enacted legislation which has acted to significantly restrict the use of "hold harmless" language in contracts. When transferring risk through any form of hold-harmless agreement, it is essential that a number of points be reviewed by competent legal counsel: Reasonable of Provisions - Harsh and restrictive language may serve to both antagonize customers .and may be invalidated in court as being contrary to both law end public policy. 1t is essential that the bank clearly understand precisely what contractual limitations of liability are legally acceptable in the jurisdiction in which the contract is to be enforced. Clarity of Language - Unclear or ambiguous language will usually be construed against the maker of the contract. Therefore, it is critical that all contracts be written clearly and that unnecessary legal 'jargon' is avoided since much of the traditional legal language has been invalidated by recent changes in statute in many countries. Disclosure of Obligations - All contracts should clearly disclose the obligations of all parties to the contract. Failure to adequately disclose obligations may make the contract un-enforceable. Financial Soundness - The bank should always ensure that the counter-parties are financially to meet their contractual commitments. It is often useful to obtain an irrevocable financial guarantee from the counter-party 3.1.2 Unfunded Retention The most common method of unfunded retention is the deductible. Also refer to section 3.2. 3 entitled Deductible. Generally deductibles should be used to eliminate coverage for losses that are apt to occur regularly. For example deductible levels of employee dishonesty should be sufficiently high to eliminate low level theft of cash by Tellers and ATM Machines. 3.1.3 Funded Retention Although more rare than unfunded programs, self insurance also includes programs where funds are actually set aside to pay incurred losses These have several significant benefits including the following: 1. Liability Accounting - By using a funded approach, the funding process goes hand in hand with an accounting system which establishes the amount of the liabilities. It is extremely useful to have an accurate measurement of year-by-year costs of operational losses - particularly as these risks grow relative to the bank’s size. This assessment ensures that significant unfunded and unrecognized liabilities are not accumulating under the self-insurance program. Furthermore, it is crucial that actuarial analysis is used for projecting losses and in determining loss reserves to avoid significant unfunded or unrecognized liabilities. 2. Service and Product Pricing - An accurate accounting and assessment of costs associated with operational losses can be important in both pricing the institution's products and services and in determining those business areas which are profitable and those which are not. 3. Investment of Funds - A funded program allows specific investment income to be earned on the funds comprising the funded loss pool. This, in turn, offsets the cost of the losses themselves.