Operational risk is commonly defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. Considering the vagueness of operational risk and given the many factors that can affect it, a number of questions quickly come to mind. How does a plan sponsor ascertain the operational strengths or weaknesses of each of their external managers? How can these risks be quantified? And how can operational risk be measured in such a way that the information is meaningful?

It is recognized that operational risk factors are qualitative and quantitative in nature and require a unique management approach. So how do you start measuring operational risk? The plan sponsor could send an audit team into each firm, but this approach is not very practical. There is no real industry standard or best practice in place, and this approach would be quite expensive. And what would you do with the results? How do you know if controls are strong or weak? And how can you compare these operational strengths and weaknesses across a diverse set of investment managers?

One proposal is to use a self-assessment approach in the form of a questionnaire that outlines the best practice capabilities within each area of the investment manager's organization. The purpose would be to compare current controls and procedures to common industry goals. Now most, if not all, of the questions would be qualitative in nature. But if you factor in a scoring rationale, or a quantitative component that weights the responses, you can start to get an idea of strengths and weaknesses in each area of the investment manager's operations. Once all your managers and potential managers have completed a self-assessment survey, plan sponsors can use the results as a basis for discussion with the fund manager, aimed at rewarding strong operational controls and discouraging non-compliance with industry standards.

The key challenge in adopting a self-assessment approach is having a consistent and industry-accepted framework. To achieve this, collaboration between plan sponsors and fund managers is essential. Implemen-tation of an industry-standard measurement will result in a win-win situation. Plan sponsors get to assess operational risk in a way that is measurable, comparable and meaningful. The implementation of an industry-standard measurement mitigates the potential of large losses due to operational inefficiencies or violations. And, compared to other alternatives, it offers a cost-efficient method of measuring operational risk.

On the other side, investment managers benefit by showcasing their strong operational controls, learning about industry best practices, proactively improving internal policies, and being well prepared for regulatory visits.

The need for plan sponsors to manage operational risk in their fund is no different than the need to measure investment risk, or any other risk for that matter. Operational risk may seem intangible in nature and often difficult to quantify, but the losses are real, and could potentially have a large impact on the future of the fund. *