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FRM Part I · FRM Exam Part I · Operational Risk

A bank uses scenario analysis to estimate a severe cyber-fraud loss. Experts estimate a frequency of once in 25 years with a severity of USD 80 million. A second scenario has once in 10 years with severity USD 30 million, and a third has once in 50 years with severity USD 150 million. Assuming the scenarios are independent and exhaustive, what is the expected annual loss from these scenarios, and which weakness of the approach is most relevant to its reliability?

Expected annual loss is USD 9.2 million, found as 80/25 plus 30/10 plus 150/50, or 3.2 plus 3.0 plus 3.0. The main weakness of scenario analysis is subjectivity, since expert estimates are vulnerable to biases such as anchoring and availability.

  1. AUSD 9.2 million; subjectivity and cognitive biases such as anchoring in expert estimatesCorrect
  2. BUSD 9.2 million; inability to include low-frequency events
  3. CUSD 260 million; double counting of frequency
  4. DUSD 3.2 million; reliance exclusively on historical internal data

Explanation

Expected annual loss = 80/25 + 30/10 + 150/50 = 3.2 + 3.0 + 3.0 = 9.2 million. Scenario analysis is designed for rare events but depends on expert judgment, so it is exposed to biases like anchoring and availability. USD 260 million sums severities, and 3.2 is only the first scenario.

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