The following literature review provides relevant information on how a Risk Maturity Model operates. The literature review focuses on the need of having risk management measurements towards their survival in the industry. On this part also, the BASEL III and SOLVENCY II models are discussed in addition to how bank and insurance risks are globally interconnected. A discussion of the BASEL II development has been detailed together with pillars which support the SOLVENCY II model and the impact it has towards the insurance industry. A review of the insurance legislations differences between Australia and Europe has also been detailed together with the construction of the risk maturity model. Finally, this chapter reviews the impact of adopting a risk maturity model detailing its benefits and shortcomings.
The needs towards risk management measurements
It is important to have risk management measurements for identifying and making assessment of the risks that faces a country with an aim to develop actions, which will offer protection. If a country or a company fails to perform risk management, it is bound to experience a financial crisis. The financial crisis has negative effects on the economy of a country, and all this is attributed to the lack of performing effective risk management contributing to inflation in a country. An example of the financial crisis was in the year 2008 when the world experienced inflation globally causing destabilization of both the developing and developed nations economy. There is a huge difference between complex financial models used to measure risk and to have a risk management system in place (Bezzina, Grima & Mamo 2014).
Companies, which are measured to be less risky, have more potential for progression than their counterparts, which face high risks. This has been attributed to the fact that these less risky companies will most likely attract new investors who are willing to inject their money into this company since they project that in the future the company will face growth. A less risky company instills confidence to the management of the company in addition to improving the reputation and public image of the company, which in the future establishes a competitive edge over other companies (Bezzina, 2010).
On the other hand, risk management affects a companys strategy in an exclusive way. An effective company will develop its strategy based on the risk management outcomes since a good strategy will be more efficient in an environment where there is less risk. In this case, therefore, a less risky company will be in a better position to develop an effective strategy. The management of the company often ensures that outcomes of the measures of the risk and forms a strategy that will avoid risky operations that may cause future unexpected problems for the company. Risk management is best used by companies to act as a preventive measure rather than a reactive measure usually being included in forming the strategy of the company. When companies make consideration of their risks when their performance in the market is well and their profitability and growth is high, they are better to form strategies that will be exclusive to copy from. The importance of risk management is controlling and preventing losses while the strategy of the company is to guide it in its future undertaking. In this sense, risk management acts as a compliment to the strategy of the company where combination of these two forms a strong company, which is ready to compete and grow.
Since the 2008 financial crises, various countries have vowed to search for improvements in risk management standards by way of trying to introduce a model, which will be capable of quantifying risk practice (Chang, et al. 2011). Risk quantification is defined as that process where countries estimate the impact of risks such as operating and financial on a country using formulas, actuarial techniques in addition to the use of statistics (Ragheb, 2011). The most appropriate approach that a country chooses to use for quantification purposes depends on the circumstances in which it is. When quantifying a countrys risk, the country may choose to either adopt active management of the risks, which are large, use a high, medium, low classification of risks, or use the refined classifications to do risk assessment. In addition to this, the company may choose to utilize statistical analysis to quantify the risks that face the country. The standards of managing risks will keep on being improved since technological developments bring with them new risks that require new ways to counter them. Risk management assessment is therefore an important aspect of a countrys economic growth while at the same time important to individual companies for them to design exclusive strategies, which will create a competitive edge over their rivals (Ragheb, 2011). A country that does risk management creates an effective and efficient environment for companies to excel in their undertakings since when they perform their individual risk management chances of reporting losses are reduced to much lower levels. In conclusion, therefore, risk management measures are important for countries and companies for the growth and profitability as well as positive economic growth respectively (Hellmich, et al. 2011).
It is important to note that measurement of the risk management only minimizes the impact of threat that the country/ organization could have realized. It is impossible to mitigate all risks usually because of the practical or financial difficulties. It is therefore vital for all organizations/ countries to accept a certain level of risks. While the risk management has been put in place to be proactive of risks, the business continuity planning is a tool, which was developed to deal with the risks, which are accepted, to a certain level (Borek, 2013). The digital era has brought about new digital risks which are associated with the increased dependence on the information technology which has become and will continue to pose great challenges presently and in the future. It is important for countries and organization to introduce the digital risk management process, which will be integrated with the strategies formulated (Borek, 2013).
Solvency II and Basel III
The SOLVENCY II as will be depicted below is a European Union Directive that aims at codifying and harmonizing the EU insurance regulations particularly on the equity that the insurance companies operating in EU most possess to ensure reduction of the risk insolvency. The SOLVENCY II model is expected to start being operational from 1st January 2016. The development of SOLVENCY II has not come without political concerns that are seen to slow down the process of implementing the model. SOLVENCY II was developed to cover more scope which the SOLVENCY I did not cover bringing on board more risk management practices. First, it reduces the insurance companys risk of being unable to meet claims, reduces losses by clients in a situation the company is unable to settle the claims fully, provide warning to the management and increase the confidence of stability in the finances of the insurance industry (Cornford, 2006).
On the other hand, BASEL III is the recent accord which was developed from BASEL I and BASEL II and majorly it was pushed by the financial crisis which was experienced in the year 2007/ 08. The purpose of BASEL III accord is to decrease the leverage of the banks while at the same time increase their liquidity. BASEL III puts focus on having reserves for the different bank deposits held by a particular bank in addition to any other forms of borrowings (Gregoriou, 2009).The main purpose of formulating BASEL III is not to supersede the BASEL II and I guidelines, however it is supposed to complement them by working alongside them. BASEL III aims at helping the banking sector to absorb any shocks that may arise from economic and financial sources, improve how the banking sector manages and governs risks and strengthens the transparency of banks and their forms of disclosure. BASEL III therefore aims to regulate individual banks by fostering greater resilience reducing the risk that can be experienced by the entire banking sector (Gregoriou, 2009).
From the below analysis, it is evident that banks and insurance companies work in a synchronizing manner and if companies or countries fail to exercise sufficient risk management and measurement they are more bound to experience future financial problems. It is, therefore, essential to perform risk management and measurement prior to forming strategies. The interconnection of risks is shown in the figure 1 below. From the figure, it is evident that financial risks are often interconnected not only between different sectors but also they are related to the international level. By defaulting a subsidiary in consideration of a credit risk, the parent bank could end up being hurt. The demand for the currency in each country results in an impact on how the exchange rate risks, commodity risks, and interest rate risks will be demanded (Svata, & Fleischmann 2011). Usually, this majorly affects the insurances and banks, which are operating across borders. It is in line with these developments that it is important for these firms, which are operating across borders to perform risk managements that will be geared to reduction of these international risks, which are, face it. For these firms to hedge out these international risks it is of importance for them to fully comply with the BASEL AND SOLVENCY regulations, which will provide support and assistance especially on how they shall form their strategies to hedge their respective risks.
As depicted in the figure 1 below, the interconnections, which are created by various risks, can often result in situations, which are more or less contagious to the financial institutions. Normally, when banks become clients of insurance companies, this is more bound to happen. When a bank, which has been covered by an insurance company defaults to repay its debt, the insurance company, is left in a position where it faces insolvency, however, the vice versa can happen, that is a bank is threatened by insolvency when an insurance company fails to meet its obligations owed to a bank.
In relation to the banks, the most important risks, which they should take into consideration, are the credit and operational risks. The credit risk that faces Banks is described as that danger where a loan taker may fail to make repayments on the loan, which he or she has, took or may fail or repay in time. This risk is also referred to as the default risk, which often results in potential loss of capital in addition to interests (Svata, & Fleischmann 2011). In the past, the credit risk was the main reason behind bank insolvencies in the past (Bessis, 2009). It is important for banks to undertake credit risk analysis in line with BASEL II with the purpose of developing risk management systems. On the other hand, the market risk deals with the trends, which are unfavorable to the financial markets. Financial instruments have adverse effects on the market prices and the most notable ones include fluctuation of exchange rates, equity risk, inflation, interest rates and commodity risks. Interestingly, the market price has effects on both the banks and insurance operations since the market risks normally affect the economy where both banks and insurance companies operate. The banks are also faced with the operational risks, which are because of internal practices and decision-making (Cornford, 2006).
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