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

In a scenario analysis for a severe data-center outage, experts estimate a 1-in-20-year frequency for the event. Severity estimates are: 40% probability of a loss of USD 5 million, 40% of USD 10 million, and 20% of USD 25 million. Insurance recovers 50% of any loss above USD 8 million, with no cap. What is the expected annual loss net of insurance?

The expected annual net loss is about USD 0.45 million. Net severities are 5, 9 and 16.5 million after insurance recovering half of losses above 8 million. Weighted average is 8.9 million per event, and dividing by the 20-year return period gives 0.445 million.

  1. AUSD 0.45 millionCorrect
  2. BUSD 0.51 million
  3. CUSD 0.38 million
  4. DUSD 0.60 million

Explanation

Net loss per event: for 5m, no recovery so 5; for 10m, recovery is 0.5*(10-8)=1, net 9; for 25m, recovery is 0.5*17=8.5, net 16.5. Expected net severity = 0.4*5 + 0.4*9 + 0.2*16.5 = 2 + 3.6 + 3.3 = 8.9. Annual = 8.9/20 = 0.445, about 0.45. Gross expected loss would be 0.4*5+0.4*10+0.2*25=11 per event, 0.55 per year, so ignoring insurance overstates the loss.

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