Impact of insurance for operational risk: Is it worthwhile to insure or be insured for severe losses?

Under the Basel II standards, the Operational Risk (OpRisk) advanced measurement approach allows a provision for reduction of capital as a result of insurance mitigation of up to 20%. This paper studies different insurance policies in the context of capital reduction for a range of extreme loss models and insurance policy scenarios in a multi-period, multiple risk setting. A Loss Distributional Approach (LDA) for modeling of the annual loss process, involving homogeneous compound Poisson processes for the annual losses, with heavy-tailed severity models comprised of α-stable severities is considered. There has been little analysis of such models to date and it is believed insurance models will play more of a role in OpRisk mitigation and capital reduction in future. The first question of interest is when would it be equitable for a bank or financial institution to purchase insurance for heavy-tailed OpRisk losses under different insurance policy scenarios? The second question pertains to Solvency II and addresses quantification of insurer capital for such operational risk scenarios. Considering fundamental insurance policies available, in several two risk scenarios, we can provide both analytic results and extensive simulation studies of insurance mitigation for important basic policies, the intention being to address questions related to VaR reduction under Basel II, SCR under Solvency II and fair insurance premiums in OpRisk for different extreme loss scenarios. In the process we provide closed-form solutions for the distribution of loss processes and claims processes in an LDA structure as well as closed-form analytic solutions for the Expected Shortfall, SCR and MCR under Basel II and Solvency II. We also provide closed-form analytic solutions for the annual loss distribution of multiple risks including insurance mitigation.