Haris Ashley
Non-financial risk (NFR) is a broad term that refers to risks other than the traditional financial risks of market, credit, and liquidity. NFRs can include operational risks, such as HR, culture and conduct, IT, data and cyber, business disruption, fraud, legal and compliance, assets, and infrastructure, as well as strategic risks. In the insurance industry, NFRs are an important focus, with many companies increasing their budgets and hiring additional talent to address these risks. Accurate assessments of the impact of risk events are crucial, as they can lead to significant financial losses, including regulatory fines and customer remediation costs.
| Characteristics | Values |
|---|---|
| Type | Operational and strategic risk |
| Examples | HR, culture and conduct, IT, data and cyber, business disruption, fraud, legal and compliance, assets, and infrastructure |
| Impact | Loss of income, regulatory fines, customer remediation costs |
| Management | Risk taxonomy, risk identification process, risk modelling |
| Mitigation | Additional talent, advanced analytics, artificial intelligence |
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What You'll Learn
- Operational risk: HR, culture, conduct, IT, data, cyber, fraud, legal, compliance, etc
- Strategic risk: business strategy and risk appetite
- Reputational risk: potential loss due to damage to a firm's reputation
- Regulatory risk: non-compliance with regulations
- Geopolitical risk: uncertainty in the economic, political, and social environment
Operational risk: HR, culture, conduct, IT, data, cyber, fraud, legal, compliance, etc
Non-financial risk is a broad term that refers to any risks other than the traditional financial risks of market, credit, and liquidity. Operational risk is one type of non-financial risk. It is the potential for loss resulting from inadequate or failed internal processes, people, systems, or external events that affect a company's day-to-day business activities. Operational risk management is crucial, especially for financial institutions, where operational losses can be unpredictable and financially significant.
The International Association of Insurance Supervisors (IAIS) defines operational risk as "the risk arising from inadequate or failed internal processes or systems, behaviour of personnel, or from external events." This includes a wide range of events and actions or inactions, such as fraud, human error, accounting errors, legal actions, and system failures. Operational risk can also encompass cyber risk, which has become a critical issue for insurance regulators due to the increase in cyber incidents such as data breaches, identity theft, ransomware attacks, and denial of service events. These incidents can result in significant costs for restoration and remediation, lost revenue, regulatory penalties, and reputational damage.
To effectively manage operational risk, senior management should be aware of the risks and strategies for overcoming them. This includes understanding the risk appetite and risk scenarios to determine how much risk to transfer to insurers and what insurance coverage is required. Additionally, institutions should consider the following key levers:
- Strategy: Incorporate all material NFRs into business strategies and risk appetite, along with appropriate metrics and risk limits.
- Three lines of defense: Reassess the risk governance model to clarify the responsibilities of each line of defense in managing NFR.
- People and culture: Develop additional skills among employees to address NFRs and build a culture that recognizes the importance of managing NFR, led by senior management.
By implementing a holistic risk management framework and comprehensive risk identification processes, institutions can effectively manage non-financial risks such as those related to HR, culture, conduct, IT, data, cyber, fraud, legal, and compliance.
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Strategic risk: business strategy and risk appetite
Non-financial risk is a broad term that refers to any risks excluding traditional financial risks such as market, credit, and liquidity risks. These non-financial risks are often operational and strategic in nature and are harder to manage due to limited data availability and the consequent difficulty in applying quantitative measurement techniques.
Strategic risk, in particular, can be effectively managed by developing a robust risk appetite strategy that aligns with the business strategy. This involves defining the level of uncertainty an organisation is willing to accept in pursuit of corresponding rewards. A well-defined risk appetite framework enables stakeholders to understand their roles in managing risks and making strategic decisions.
Senior management and boards play a crucial role in translating the universal risk appetite statement into a practical framework for the business. They are responsible for aligning business strategies with the organisation's risk management approach, ensuring that strategic decisions do not result in unacceptable risks being taken to meet profitability targets.
To effectively align business strategy with risk appetite, it is essential to establish a clear process and explicit ownership for incorporating non-financial risks into the business strategy. This includes implementing appropriate metrics and risk limits, as well as developing the skills and culture necessary to address these risks effectively.
Additionally, the calibration of risk limits should be considered in conjunction with business strategies. This calibration must be dynamic, taking into account internal factors such as credit underwriting standards, portfolio concentration risk, and emerging risks from new product lines. Furthermore, external market conditions and macroeconomic trends should be evaluated to establish comprehensive risk limits.
By integrating these considerations into their strategic decision-making process, organisations can effectively manage strategic risk: business strategy and risk appetite.
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Reputational risk: potential loss due to damage to a firm's reputation
Non-financial risk refers to risks other than those managed directly by the finance department, such as market, credit, and liquidity risks. Instead, non-financial risk concerns operational and strategic risk. Reputational risk is a type of non-financial risk that can lead to financial loss or legal problems for a company.
Reputational risk is the potential for damage to a firm's reputation due to specific events, actions, or failures. It is the threat that something could damage the trust, credibility, or image of a business. For example, negative customer experiences can lead to bad reviews and word-of-mouth, which can quickly tarnish a company's reputation. Similarly, a surge of negative reviews on social media or review platforms can damage a business's image and deter potential customers.
Data breaches or leaks are another example of reputational risk. A breach of customer data can erode trust in a company's ability to protect sensitive information. In the case of a data leak, the reputation of the company as a whole might be at stake.
To protect against reputational risk, companies can purchase reputation insurance, which is typically offered as part of a more comprehensive business insurance policy. This insurance can cover losses in sales resulting from brand-damaging incidents. Crisis management insurance, a type of reputational risk insurance, covers the emergency use of public relations (PR) teams to mitigate any future damage that could occur to a brand’s reputation following a public incident.
Additionally, companies can implement risk management strategies to reduce their exposure to reputational harm. This includes monitoring online reviews and mentions, responding promptly to negative feedback, developing a crisis communication plan, and training employees on ethics and conduct.
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Regulatory risk: non-compliance with regulations
Regulatory risk is a type of non-financial risk that insurance companies face. Non-financial risk refers to risks other than the traditional financial risks of market, credit, and liquidity. Non-compliance with regulations is a significant concern for insurance companies, as it can lead to severe consequences, including financial and reputational damage.
Insurance companies are subject to various state and federal regulations, and ensuring compliance with these regulations is crucial. Non-compliance can result in hefty fines, punitive damages, legal penalties, and reputational harm. For example, insurance companies must comply with regulations related to money laundering, such as the Bank Secrecy Act, and the storage of private and personal customer information. Non-compliance with anti-money laundering (AML) regulations can lead to fines and sanctions, restricting the company's ability to conduct business.
To manage regulatory risk effectively, insurance companies should implement robust compliance programs. This includes regularly monitoring regulatory changes, subscribing to updates, and consulting legal experts to stay informed about new and evolving requirements. Compliance teams play a vital role in identifying relevant regulations, understanding their implications, and ensuring that the company's policies and procedures align with these requirements.
Additionally, insurance companies should utilize modern technology to facilitate compliance. Many software solutions offer data storage, reporting, and process automation capabilities, reducing the risk of human error and improving efficiency. By adopting these tools, companies can simplify the process of achieving and demonstrating compliance.
Furthermore, insurance companies should pay attention to third-party risk management. It is essential to ensure that third-party vendors and partners comply with relevant regulations through regular due diligence and assessments of their compliance practices. By proactively addressing these challenges, insurance companies can better manage their regulatory responsibilities and avoid the high-stakes consequences of non-compliance.
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Geopolitical risk: uncertainty in the economic, political, and social environment
Non-financial risk refers to risks other than those managed directly by the finance department, such as market, credit, liquidity, and insurance risk. Instead, non-financial risk concerns operational and strategic risk. Operational risks include HR, culture and conduct, IT, data and cyber, business disruption, fraud, legal and compliance, assets, and infrastructure.
Geopolitical risk is a type of non-financial risk that insurance professionals must understand to navigate the immediate impacts on policy and coverage and to strategize long-term resilience and adaptability. Geopolitical risk refers to the uncertainty in the economic, political, and social environment, which can be caused by elections, polarisation, conflicts, and military tensions between states. These events have knock-on effects on the global economy and individual countries, as well as on financial markets and trade. For example, the war in Ukraine and the conflict between Israel and Hamas in the Middle East have disrupted global economic performance.
Furthermore, the outcome of elections in large democratic nations such as the US, UK, South Africa, and India, can have a profound effect on geopolitical ties, politics, and the direction of ongoing global conflicts. Socio-economic challenges, such as social unrest due to contracting job markets and faltering economies, can also be considered critical focal points for geopolitical risk.
The assimilation of artificial intelligence into various sectors is another factor that can influence geopolitical risk. While it has the potential to unlock new innovations and bring significant productivity gains, it can also exacerbate social issues and threaten to displace significant portions of the workforce.
To effectively manage non-financial risks, financial institutions should implement a holistic risk management framework. This includes a comprehensive risk taxonomy and a robust risk identification process to assess and mitigate non-financial risks.
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Frequently asked questions
Non-financial risk refers to risks other than those managed directly by the finance department, such as market, credit, and liquidity risks. In the context of insurance, non-financial risks can include operational risks, strategic risks, and reputational risks.
Examples of non-financial risks in insurance include data leaks, cyber incidents, non-compliance, misconduct, and fraud. These risks can have significant impacts on insurance companies, including financial losses, regulatory fines, and damage to reputation.
Insurance companies can take a strategic approach to managing non-financial risks by investing in risk management frameworks, developing additional skills among their employees, and utilizing advanced analytics and artificial intelligence to identify and mitigate these risks effectively.
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