Forum. Risk-adjusted Operational Risk Reserves: a challenge for superannuation funds? A meeting place for views and ideas

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1 Forum A meeting place for views and ideas Risk-adjusted Operational Risk Reserves: a challenge for superannuation funds? The Government s proposal to introduce Risk-adjusted Operational Risk Reserves may have significant implications for many funds that either do not have an Operational Risk Reserve, or for those few funds which do, in the manner in which their reserves are managed. A review of industry funds based on publicly available documents shows that while a number of funds have general reserves which appear to be a good base for the formation of an Operational Risk Reserve, very few have a specific Operational Risk Reserve, and many other funds have reserves that are likely to be inadequate to meet upcoming requirements. Published March 2011 Tony Miller Senior Consultant Actuarial and Benefits Consulting Russell Investments

2 Risk-adjusted Operational Risk Reserves: a challenge for superannuation funds? The Government s proposal to introduce Risk-adjusted Operational Risk Reserves may have significant implications for many funds that either do not have an Operational Risk Reserve, or for those few funds which do, in the manner in which their reserves are managed. A review of industry funds based on publicly available documents shows that while a number of funds have general reserves which appear to be a good base for the formation of an Operational Risk Reserve, very few have a specific Operational Risk Reserve, and many other funds have reserves that are likely to be inadequate to meet upcoming requirements. Operational Risk Reserves In June 2010, the Cooper Report included a recommendation that superannuation funds hold a minimum level of Operational Risk Reserves. This proposal received in principle support from the Government in December The Government also confirmed it supported a risk-based approach, where the amount required to be held will be calibrated to the risks faced by individual funds. The Government is consulting with industry on the framework for the proposed requirements and no clear direction is evident as yet. However, funds are already contemplating what the proposed changes may entail and what those changes might mean for them. In this paper, we consider the question of Operational Risk Reserves from the perspective of not-for-profit funds. We examine a basis for establishing an Operational Risk Reserve, including a discussion on how this method might be aligned with APRA s existing risk assessment process ( Probability and Impact Rating System, or PAIRS ). On this basis, we find that many funds currently have reserves that may be inadequate to meet the proposed requirements. On a risk-adjusted basis, many funds will need to build extra reserves, or reduce risks (or both). We also outline the key issues that funds will likely face in building and managing the reserve. Operational Risk? APRA has defined Operational Risk as: the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Exposure to this risk can result from deficiencies or breakdowns in internal controls or processes, technology failures, human errors, dishonesty/fraud and external events (e.g. physical infrastructure failure or natural disaster). 1 Fintan Thornton Senior Consultant Actuarial and Benefits Consulting Russell Investments 1 Probability and Impact Rating System, APRA, November

3 Note that this definition of operational risk excludes costs to implement changes in response to legislative or industry developments. Such costs are assumed not to be met from the Operational Risk Reserve, but from other monies (eg. from a general reserve). In this paper, we have focussed on the operational risk component of reserves, while acknowledging the need for other general reserves as well. For superannuation funds, common examples of operational risk include unit pricing or crediting rate errors, failures to maintain adequate member records, as well as administration failures that result in incorrect benefits being paid to members, privacy breaches and other legislative breaches. In fact, industry experience shows that the list of potential risk events is large, even though the probability may be small. Operational Risk Reserves What purpose do they serve? Having effective controls and strong processes clearly assists in reducing operational risk incidents. In a not-for-profit fund, the role of the Operational Risk Reserve is to provide funds for rectification without recourse to member accounts, undistributed investment earnings or other reserves. The existence of the reserve allows the trustee to continue to develop member services with reduced concern that additional funds will be needed to cover an unexpected event. When incidents do arise in respect of outsourced services, trustees may be able to obtain compensation from their service providers in due course, eg. where the incident arose due to an error by an administrator or custodian. However, such compensation may not be available immediately. Having funds readily available in an Operational Risk Reserve to meet immediate payments greatly facilitates the restoration process. On a risk-adjusted basis, many funds will need to build extra reserves, or reduce risks (or both). There are also other circumstances where the cost of an operational risk incident will need to be permanently met from internal funds. If the incident relates to an internally provided service (eg. where the fund is administered internally), it will not have recourse to third party compensation. Alternatively, if fund administration is outsourced, the cost of the incident may exceed the service provider s limit of liability. Reserves do not guarantee zero risk APRA has endorsed the Government s stance on the role of prudential regulation: prudential regulation cannot and should not seek to guarantee a zero failure rate of prudentially regulated institutions or provide absolute protection for market participants (including consumers). 1 APRA s statement relates to the risk of failure of regulated entities. In our view, the same logic applies to the establishment of Operational Risk Reserves. An Operational Risk Reserve does not guarantee coverage of all operational costs arising from a rectification. This would be impossible without requiring unrealistically high reserve levels. We contend that the dynamics in a not-for-profit superannuation fund are quite different to those in other financial institutions, such as banks. Bank customers are offered a high degree of protection on their bank savings and are largely protected from the bank s operational losses because these risks are borne by bank shareholders. Alternatively, not-for-profit superannuation funds generally do not guarantee that members will not partake in funding operational costs. Members will likely share in funding this cost either through the build up of reserves or through the payment of operational costs where reserves are insufficient. The funding of superannuation fund benefits is ultimately sourced from contributions made by both members and employers. If an Operational Risk Reserve is exhausted, a not-for-profit superannuation fund would necessarily need to access member or employer funds. An Operational Risk Reserve would allow operational costs to be gradually funded over a longer period, and would serve to achieve more equitable funding of such costs. In our view, the above considerations should be reflected in the requirements for setting a standard reserve. How much do superannuation funds currently hold in reserves? An examination of the publicly available information of industry funds shows a wide diversity of results with respect to reserves. Clearly a wide range of practices have applied, but there is very limited evidence of a structural approach to setting an Operational Risk Reserve. 1 Probability and Impact Rating System, APRA, November

4 Chart 1: Reserves currently held by superannuation funds Reserves as % of Assets Reserves as % of Annual Operating Costs % % % of Assets % of Annual Operating Cost $500 $1,000 $1,500 $3,000 $4,000 Fund size ($m) 0 The above chart, covering funds with up to approximately $4 billion in assets, shows little correlation between superannuation fund size and the amount of reserves held. It also shows a wide range of reserves held when expressed as a percentage of operating cost, reserves range from 0% to over 300%. Setting a standard basis for the reserve So how does a fund determine a suitable level of reserve how big should it be? As a starting point, we suggest adopting a Standard Operational Risk Reserve for each fund, which can then be adjusted for the fund s specific risks. A one-size fits all approach is unlikely to give a satisfactory outcome, given the potential for some fixed costs to be incurred in an operational risk event. In our view, aspects that should be reflected in the size of the Standard Operational Risk Reserve include the fund s size, the fund s annual operating costs, and the degree of outsourcing. In this context it is important to distinguish between outsourcing to independent third parties, rather than to related parties. We have proposed the following structure for determining Standard Reserves based upon research to-date within the industry: Table 1: Standard reserve (% of annual operating costs) Fund size Internal operating costs Outsourced operating costs Up to $1 billion 125% & 75% $2.5 billion 100% & 50% $5.0 billion 90% & 45% $7.5 billion 85% & 40% Higher than $10 billion 70% & 30% The Standard Reserve allows for the different risk and reserving requirements for outsourced and internal operations. However, it is not yet calibrated to an assessment of the fund s internal processes and controls. The suggested process for such calibration will be discussed in the next section. Example: Setting a Standard Reserve The above basis can be seen in practice by considering four separate funds of different fund size and annual operating cost. For this example, we assume the funds operating costs are evenly split between internal and outsourced functions. Clearly this will vary from fund to fund. 3

5 The Standard Reserve would be calculated as: Table 2 Fund Size Annual Operation Costs Standard Reserve Total Internal Outsourced Sample calculations A $1b $8.0m $0.8m $7.2m B $2.5b $14.0m $4.2m $9.8m C $5b $22.0m $11.0m $11.0m D $10b $50.0m $30.0m $20.0m $0.8m x 125% + $7.2m x 75% = $6.4m Equivalent to 0.6% of assets $4.2m x 100% + $9.8m x 50% = $9.1m Equivalent to 0.4% of assets $11m x 90% + $11m x 45% = $14.9m Equivalent to 0.3% of assets $30.0m x 70% + $20.0m x 30% = $27.0m Equivalent to 0.3% of assets The above example assumes smaller funds have a larger proportion of outsourced costs, and larger funds have a larger proportion of internal costs (including costs outsourced to related parties). Comparison against reserves currently held by funds In the graph below, we illustrate how this basis might apply to funds themselves. The following chart, based on publicly available information, plots the difference when we take each fund s current level of reserves minus the standard reserve we have modelled using the above basis. A negative value means the total reserves currently held by the fund are less than the modelled reserves. We find that for most funds with less than $3 billion in assets, the level of reserves currently held are generally lower than the standard reserves modelled on the above basis. For funds where the reserves currently held could be used for other purposes, rather than just be used to establish an operational risk reserve, the potential shortfall for the operational risk reserve would be even more striking. Chart 2: Most funds under $3B: Reserves currently held are below modelled reserves % Difference: Current Reserve minus Modelled Reserves (% of Net Assets) $500 $1,000 $2,000 $3,000 $4, Fund size ($m) For the purpose of this chart, we have adopted some simple assumptions to split internal and outsourced operating costs based on fund size. 4

6 Standard reserve to be risk-adjusted The Government has indicated that it supports in principle the recommendation for the Operational Risk Reserves to be calibrated to each fund s specific risks. A process of calibration will typically be quite subjective. We suggest that a Risk-Adjustment Factor be determined for each fund by APRA, through APRA s risk assessment process ( PAIRS ). The risk adjusted reserve would then be as follows: Risk-Adjusted Operational Risk Reserve = Standard Reserve x Risk-Adjustment Factor The Risk-Adjustment Factor would be drawn from an assessment of the fund s probability and impact of operational risk. Suggested Risk-Adjustment Factors are provided below: Table 3: Risk-Adjustment Factor Operational Risk impact rating 2 Operational Risk Probability rating 1 Low Lower Medium Upper Medium High Extreme Extreme * * High * Medium * Low * * As determined on case by case basis by APRA. 1 The Operational Risk Probability Rating would represent the fund s probability of operational risk failure. It would be determined by APRA based on the fund s Quality Assessment Score for Operational Risk under PAIRS. 2 The Operational Risk Impact Rating would reflect the potential financial impact on members if the Operational Risk Reserve is insufficient to meet the cost of operational risk events. This rating could also be determined by APRA under PAIRS. For example, under such a system, a fund with a Risk- Adjustment Factor of 1.2 would need to target Operational Risk Reserves equal to 1.2 x the Standard Reserve. The Cooper Report suggested a minimum level of reserve be adopted. In our view, it is important that funds be given the flexibility to allow reserves to drop below the targeted level (eg. when reserves are used to meet operational costs). Whenever this occurs, the reserve should be allowed to be gradually rebuilt over an appropriate time period. Otherwise, if reserves are required to be immediately restored to a prescribed minimum level, members in notfor-profit funds would still suffer a large impact on their superannuation at the time of the operational risk event. This outcome would defeat the purpose of establishing the reserve in the first place. Further considerations Once the target size of the Operational Risk Reserve is determined, further issues relating to the establishment and maintenance of the reserve also need to be considered. The latest fund data for the not-for-profit sector shows that although some funds have a reasonable level of reserves, many currently have reserves that may be inadequate to meet the Cooper Report s proposed requirements for establishing risk-adjusted operational reserves. If the proposal goes ahead, actions will be needed to build reserves, typically by reducing returns to members for a period and possibly to reduce risks. Some of these issues are set out in the Table below. Many of these are issues on which Russell s actuaries are engaging with clients, and using Russell s modeling tool (the Total Fund Evaluator ), to examine possible solutions. Table 4 Establishing the reserve What is current level of reserves how have they been created? How much of current reserves can be equitably allocated to operational risk? Over what period of time could the reserve be built up? How would the reserve be built and how is it to be done equitably across generations of members? Would different categories of members be charged different amounts? The concurrent accrual of other reserves must also be considered. Ongoing maintenance If the reserve is accessed to cover the cost of an operational error, over what period would the reserve be rebuilt? If the reserve falls below target, what levers would funds have in equitably driving their reserve back towards the target across generations of members? Investment How would the reserve be invested? - Two obvious options are the default option (generally a balanced or growth type option), or a cash option. How will the outcomes differ? Monitoring and re-assessment Provision of information for ongoing monitoring: - We expect that regular reporting to the Trustee on the movements in, and level of, the reserve will become standard practice. - We further expect that if Risk-Adjusted Operational Risk Reserves become mandatory, annual reassessment of the reserve will become a standard component of APRA reporting. 5

7 References Super System Review Final Report, 30 June Stronger Super Government Response, 16 December Probability and Impact Rating System, APRA, November Supervisory Oversight and Response System, APRA, November Super: the case for microeconomic reform An address to The Committee for Economic Development of Australia (CEDA), Jeremy Cooper, Chair, Super System Review, 26 May Super System Review - Default Fund costs under the MySuper proposals, Deloitte, 19 April Operational Risk Reserves Current market practices and attitudes, Mercer, August Cooper Report: the value of advanced modelling to assist trustees meet their requirements, Russell, July SPG Use of reserves in superannuation funds, APRA, 29 April GPG Operational Risk, APRA, February LPG 230 Operational Risk, APRA, March APG 115 Advanced Measurement Approaches to Operational Risk, APRA, January

8 For more information contact Russell: Phone Sydney Melbourne Website Address Level King Street Sydney NSW 2000 Tony Miller Senior Consultant Actuarial and Benefits Consulting (03) Fintan Thornton Senior Consultant Actuarial and Benefits Consulting (02) Issued by Russell Investment Management Ltd ABN , AFS Licence ( RIM ). This document provides general information only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation and needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Any potential investor should consider the latest Product Disclosure Statement ( PDS ) in deciding whether to acquire, or to continue to hold, an investment in any Russell product. The PDS can be obtained by visiting or by phoning (02) RIM is part of Russell Investments ( Russell ). Russell or its associates, officers or employees may have interests in the financial products referred to in this information by acting in various roles including broker or adviser, and may receive fees, brokerage or commissions for acting in these capacities. In addition, Russell or its associates, officers or employees may buy or sell the financial products as principal or agent. Copyright 2011 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. R_NEW_Forum_RiskReserv_V1F_1103 MKT/2899/0311