Insuring versus self-insuring Operational risk: Viewpoints of depositors and shareholders

Operational risk refers to low-frequency, high-severity, events that threaten the solvency of a bank and contribute to the tail of its loss distribution. Operational risk is unlike market and credit risk; by assuming more of it, a financial firm cannot expect to generate higher returns. Operational risk destroys value for all claimholders. To mitigate operational risk, a bank can improve its controls, upgrade its infrastructure and redundancies, or buy insurance against its operational risk exposure. None of these alternatives comes for free. The cost associated with each should be compared to the benefit of reducing the frequency of operational risk events and the loss when an event occurs. Under what conditions and terms should a bank buy insurance against an operational risk exposure? There are certain issues related to conflicts of interest in a bank between shareholders and depositors, and between them and regulators.