Operational Risk in the Insurance Industry

Operational risk has increased in importance in the insurance industry over recent years. The actuarial process for product formulation, the long duration of many insurance products, and the need to match assets and liabilities in time mean that deviations in product performance, stemming from operational risk, have large impacts on the insurers' profits. Operational risk is embedded in the functions of an insurer. Detecting operational risk is challenging, as it is often hidden in product performance as unexpected losses and experienced years after products are sold. Research findings show that operational risk in the insurance industry is increasing in size over time, occurring most frequently and severely in the handling of customer interactions. The product complexity and customer interaction that is inherent in the insurance business leads to an operational risk profile that is different than other financial institutions, and one that appears to be more expensive in terms of cost of capital. Operational risk is, at its core, an error in a decision or process that impacts the policyholder, and can, through contagion, result in regulatory fines, poor product performance, and persistent reputational harm. Managing operational risk in the insurance industry ultimately requires promoting a culture that is data-driven and a management philosophy that invests in understanding complexity and developing process excellence. Setting a standard for preventing errors and seeking explanations for errors is critical to managing operational risk and preventing the spread of further, more damaging risks to the insurer.