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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

A bank's operational risk team is designing its internal loss data collection policy. Which of the following is the most appropriate reason to set a minimum collection threshold (for example, EUR 10,000) for recording loss events?

A collection threshold lowers the cost of recording very small losses, but it left-truncates the dataset. The truncation must be accounted for when fitting severity and frequency distributions, otherwise the parameters and capital estimate will be biased.

  1. AIt removes all low-frequency, high-severity events from the dataset so that the severity distribution is better behaved
  2. BIt reduces the cost of collecting very small losses, while the resulting truncation must be accounted for when fitting the severity distributionCorrect
  3. CIt guarantees that the frequency distribution is unaffected, because small losses carry no information about event counts
  4. DIt allows the bank to exclude losses below the threshold from the capital calculation without any statistical adjustment

Explanation

Thresholds make collection practical and cost-effective, but losses below the threshold are missing, so the data are left-truncated. Severity fitting must adjust for this, and frequency must be estimated for events above the threshold. Excluding small losses without adjustment (the last option) biases the parameters.

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