Sandra Giuffre's principal interest is operational risk financing for financial institutions, where she is highly regarded for her ability to identify issues, create appropriate analytics, and develop solutions. Sandra began her career in securities and moved to the insurance industry in the mid-1980s. In 2002, she co-chaired an operational risk initiative for the ITWG. She was previously a managing director, and the FINPRO Global Operational Risk Practice Leader, Marsh, Inc. Combining her modeling and risk-transfer capabilities, she began to develop and evaluate methodologies for making the "operational risk--risk transfer" relationship explicit. In 2004, Sandra presented a program on operational risk and insurance at an internal Federal Reserve conference. Founding Giuffre Associates in 2005, she is now focusing on improving the ability to properly value insurance as a mitigant for risk and creating effective and efficient risk-transfer solutions, including new capital market insurance-based products. Charles Taylor recently had a conversation with Sandra Giuffre of Giuffre Associates about the potential value of insurance as an effective operational risk mitigant.
Taylor: Sandra, the insurance industry continues to miss an extraordinary opportunity to provide banks with operational risk insurance. They continue to sell traditional insurance policies that offer incomplete, overlapping, and uncertain coverage. What are your thoughts?
Giuffre: Insurers need to borrow a leaf out of the derivatives markets' book and create effective and efficient products that banks can rely on. These products must be tailored to fit with the way that banks segregate and manage their risks. Banks can help insurance companies provide the right type of policies by sharing their perspective and language, and then helping them develop the right requirements for these policies.
Taylor: What is the payoff for the banks?
Giuffre: This effort could pay off handsomely as banks would be able to transfer their operational risks to insurance companies for a lot less than the cost of capital they apply to them now. (1)
For example, assume a bank's cost of capital is 12%. In today's markets, the risk of damage to physical assets can be transferred by banks to insurance companies using property insurance for 4% or less, a savings of 8%. If a bank allocates $500 million in capital for damage to physical assets, the 12% opportunity cost of that capital would come to $60 million a year. If, on the other hand, it bought insurance at 4%, the out-of-pocket cost would be $20 million. So there is the potential for $40 million in savings for the bank per year.
Depending on the bank and the type of risk, the spread between the cost of capital and that of insurance can be significant. Some banks are allocating billions in economic capital for all of their operational risks, so the potential savings can be very large and well worth the effort.
Taylor: Fundamentally, why is it that insurance companies can bear these risks at lower costs than banks? Large banks are very well diversified; they know their risks better than any insurance company ever can, and they are financially sophisticated. Is it really plausible that there should be a lasting opportunity for insurance companies and banks to do business?
Giuffre: One reason is because insurance companies are very familiar with tail events. A prime example is disasters: Because insurance companies know a lot about earthquakes and other infrequent loss events, they are able to develop competitive disaster-related insurance. And on top of this, as they build disaster-related portfolios, the big insurance companies can pool and diversify these tail events far better than banks.
Then there are some risks that are inherently difficult for banks to diversify. One example is the risk covered by directors and officers liability. Although a D&O-related loss event can be comparatively small in relation to capital, it is often highly correlated with other risks in the bank. …