Suggested Solutions

Assignment 03
Operational Risk Management

RSK4801

Department of Finance, Risk Management

and Banking
This tutorial letter contains important
information about your module.

Open Rubric
Question 1 [30]

Reliable electricity supply has been identified as a priority by the board. The managing director has
requested you to evaluate the current strategy with regard to the electricity supply to the production
facilities, with regard to the events, causes for the events and the impact of the events. Your
evaluation should also include key supplier dependencies. Argue what actions the company can
implement to mitigate the impact of similar future events.

a. Electricity supply events, causes and the impact. (15)

From and electricity supply perspective, the company is reliant on two suppliers, the national supplier
and the electricity supplied by the backup generators. Both can be regarded as key suppliers, as
without electricity, a large component of the business will not be able to sustain its business.

The electricity supplied by the national grid is outside the control of the company as the company is
a buyer of the available supply.

The company can control the backup generating capacity, but is then exposed to the cost to creating
and maintain an infrastructure within the budgetary constraints. The company must also ensure a
sufficient fuel supply for the generators and although storage capacity for the fuel can be increased,
the fuel needs to be replenished.

The company increased its backup capacity after it experienced the shortfalls from the national grid
in 2012. The fuel strike in 2013 had a severe impact on production as the company ran out of fuel to
maintain production. The fuel storage tanks had insufficient capacity for production longer than 2
hours at the Main Production Facility and 4 hours at the Value Added Facility. The fuel is supplied by
one primary supplier, which can be regarded as a single point of failure should the primary supplier
not be able to supply the fuel.

The financial impact of the business interruption was R700 million for 2012 and R900 million for
2013. In terms of the Operational Risk Evaluation Matrix, the monetary impact can be rated as 3 for
2012 and 4 for 2013. The amount that the company was able to claim was limited to R5 million for
2012 and R7 million for 2013.

Another impact that should be considered is the loss of markets, especially international markets as
 RSK4801

a component of the catch of fish is exported. The impact can be severe if Healthy Fish loses its
international accreditation as it may be difficult to recover. From a reputational perspective the
company can be regarded as an unreliable supplier and customers may decide to seek alternative
suppliers.

b. Actions that the company can take to mitigate similar future events. (15)

It is clear from the analysis that the business interruption caused by the electricity can be
catastrophic for the company. The company can take the following actions to mitigate similar future
events:

1. Review insurance policies with regard to spoilage of products. The amounts that the company was
able to claim for spoilage of the catch were below the actual loss. The policy should be reviewed to
provide for a more realistic projection of losses which caused interruption in the electricity supply.
The company can also consider setting up a captive.

2. Increase the onsite fuel storage facilities. The current storage facilities for the backup generators
are limited to 2 000l for both plants. The risk management department should perform a detailed
analysis of the usage of fuel over the last two years to determine the optimal onsite storage facilities.
The calculation should incorporate the possibility that the supplier may be prevented from delivering
top-up fuel.

3. More than one fuel supplier. The primary fuel supplier was not able to provide fuel during the
strike, which caused a single point of failure during the transport strike. The company must appoint a
primary and secondary supplier for both sites. The primary and secondary suppliers should
preferably be different where possible to maintain supplies should the primary supplier be prevented
from delivering fuel.

4. Consider installing wind/solar backup facilities. The company is reliant on the national grid as the
main supplier of electricity. To rely on diesel generators for backup is expensive and can be
prohibitive for prolonged periods. The company should consult with energy experts on solar or wind
energy as alternative for the backup generators. If feasible, the benefit is that both forms are
renewable and can be used as the main supply with the national grid supplying the shortfall. The
current backup generators can then be activated when necessary.

3
Question 2

a. Discuss the characteristics of good risk indicators. (15)

The following can be regarded as characteristics of good risk indicators:

• Relevance
The risk indicator must be linked to the organisation’s operational risk exposures and provide
management with a quantum regarding the levels of exposure and degree to which such exposures
are changing over time. It is also important to review indicators periodically for relevance as it can
also change over time from the perspective of the users of the indicator.

Three criteria can be used to determine relevance:

 Specific focus indicators: Focused on a single exposure area.
 General focus indicators: Cover a specific area of activity and provide a general
impression of current exposure levels or activity.
 Common or generic indicators: Can be used anywhere in the business, usually by
adding specific context.

• Measurable
Risk indicators must be capable of being measured repeatedly and with certainty. To be measurable,
it should meet the following criteria:
 Must be quantifiable as an amount, percentage, ratio, number or count.
 Must have values which a reasonably precise and a definite quantity.
 Must be comparable over time.
 Must be reported with primary values and be meaningful without interpretation or
some subjective measure.

• Predictive
Indicators can provide a leading, lagging or current perspective of the operational risk exposures of
the organisation.

Although there is a need for leading indicators, this is the most difficult to develop as a simple
projection of the future based on historical events will most probably sacrifice accuracy and therefore
reliability. For an indicator to be fully predictive requires significantly more context, which implies that
single indicators by themselves are of little use. To overcome this challenge, practitioners are
moving towards the development of composite or index indicators. An important requirement to
develop a composite or index indicators is to understand both the causal and underlying relationship

4
 RSK4801

with specific datasets to ensure the appropriate groupings of related indicators.

Lagging indicators provide useful information regarding the historical causes of a loss or exposure. It
can also be useful where losses are initially hidden or where changes in historical trends may reflect
changes in circumstances that may have some predictive qualities.

Current indicators provide a current view of operational risk exposures and may identify a situation
that requires attention to reduce an exposure or minimise a loss.

b. Argue the risk indicators that you would recommend that the company should implement to
monitor the electricity supply. Differentiate between risk indicators and key risk indicators. (5)

Risk indicator or key risk indicator (KRI)

A metric that provides information at the level of exposure to a given risk, which the organisation
has at a particular point in time. Key risk indicators can be regarded as the most important risk
indicators at that point.

For the company, which is experiencing frequent interruption in the electricity supply a key risk
indicator will be the levels of fuel in the storage facilities.
Capacity – available, required, used
Any other appropriate example(s) applicable to the case study was considered.

Question 3 [20]

a. The board recommended that scenario analysis should be used to consider systematically the
risk of extreme but plausible events. Describe operational risk scenarios. (5

Scenario analysis involves the examination of rare, significant, yet plausible future events, taking
into consideration the alternative possible outcomes for those events, and assigning probabilities to
the various scenarios. Scenario analysis is a tool to look into the future and provides the ability to
combine unexpected risks/events. Scenarios also help to overcome some of the limitations of
models and historical data. Scenarios support both internal and external communication as it gives
transparency to management’s thinking or opinion about the organisation’s exposure to operational
risk. Scenarios should enable management to answer the following questions:

5
• Where are we?
• How to respond?
• What could hurt the organisation?

The following did not form part of the question, but students could have earned marks for
mentioning it.
Scenario analysis require the following information:
• Historic information
 Past performance
 Loss data
 Cycle reoccurrence
 Historic information tells us about the future
• Present
• Metrics
• MIS
• This serves as a ‘warning gauge’ as to what needs to be fixed
• Future
• Risk Assessment (short-term)
• Scenario Analysis (long-term)
(Students could also earn marks if they used relevant examples from the case study).

b. Biases are one of the concerns when developing operational risk scenarios. Argue the
measures that can be implemented to mitigate biases when developing operational risk
scenarios. (15)

Scenario Analysis involves the examination of rare, significant, yet plausible future events, taking
into consideration the alternative possible outcomes for those events, and assigning probabilities to
the various scenarios. A bias can be described as a conscious or subconscious discrepancy
between a participant’s response when developing a scenario and an accurate description of the
participant’s underlying knowledge. Human limitations, in the ability to process data and
information, can often lead to assessments that are poorly calibrated or internally inconsistent.
Availability: Assessments depend on our memory, or our ability to imagine an unfamiliar scenario.
Anchoring: Presenting workshop participants with internal or external loss data that anchor their
assessments on those values.

Partition Dependence and Granularity: Dividing the set of possible outcomes into ‘buckets’ or

6
 RSK4801

ranges can potentially increase the level of uncertainty in the estimate. If the ranges are too
narrow, the subject may be unable to decide which band to choose; if too wide, they may feel that
their answer is uninformative.

Motivational Bias: Managers have an incentive to understate potential losses in order to reduce
the capital that is allocated to their business unit. Managers may feel uncomfortable making
scenario assessments at extreme percentiles, and may become defensive when asked to consider
the fallibility of their controls.

The following actions can be taken to reduce biases:

• The use of a facilitator with elicitation skills can assist the subject matter experts to interpret
statistical terms and concepts, and can identify any inconsistencies or biases that may arise.
• Graphical or visual playback can be used to verify that the elicitation is consistent with the
expert’s underlying beliefs.
• Thorough documentation provides transparency for third parties to interpret the rationale behind
the assessments, and allows the evaluation of consistency within and across assessments.
• The challenge and verification process can identify and correct assessments that are illogical,
inconsistent, or incoherent. Challenge can take place during the workshop if multiple experts
challenge each other, or from the normative expert acting as facilitator. Challenge can also take
place outside the workshop by those who are higher up in the organisation, topic experts, for
example from IT or HR, and those who span all across the organisation such as the Group
Operational Risk function.

Five techniques that can be used in validation of scenario assessments are:

• the “two pairs of eyes principle”
• internal audit of the risk assessment process
• comparison of actual losses against experts’ expectations
• comparison of the outcome of scenario assessments against internal audit findings
• challenge by Group functions such as HR, Risk, Finance

©
UNISA 2015