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FRM Part II · FRM Exam Part II · Digital Resilience and Financial Stability: The Quest for Policy Tools in the Financial Sector

A reinsurer models a cyber catastrophe pool of 10 banks, each with a 2% annual probability of a vendor-driven loss of 50 million. Losses are independent in Model A. In Model B, a single vendor event with 2% probability hits all 10 banks at once. Which statement correctly compares the two models?

Expected annual loss is 10 million in both models (10×2%×50 and 2%×500). However, Model B concentrates loss into a single 500 million event, so its tail risk is far greater. Correlation from a common vendor raises tail risk without changing the mean.

  1. AExpected annual loss is 10 million in both models, but Model B has far greater tail riskCorrect
  2. BExpected annual loss is 10 million in A and 100 million in B
  3. CExpected annual loss is 1 million in both, with equal tail risk
  4. DExpected annual loss is 10 million in both, and Model A has greater tail risk

Explanation

Model A: 10 × 0.02 × 50 = 10 million. Model B: 0.02 × (10 × 50 = 500) = 10 million. Means are equal, but in B the 2% event costs 500 million, whereas in A the chance of several simultaneous losses is tiny. Correlation therefore fattens the tail without changing the expectation.

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