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

Under a loss distribution approach (LDA), a bank models a single risk cell with annual frequency Poisson with mean 20 and a severity distribution with mean loss of USD 50,000 per event. Assuming frequency and severity are independent, what is the expected annual loss for this cell?

The expected annual loss equals expected frequency times expected severity, so 20 events multiplied by USD 50,000 gives USD 1,000,000. This holds when frequency and severity are independent, as assumed in the loss distribution approach.

  1. AUSD 2,500
  2. BUSD 100,000
  3. CUSD 1,000,000Correct
  4. DUSD 50,000

Explanation

Expected aggregate loss = E[N] x E[X] = 20 x 50,000 = USD 1,000,000. USD 100,000 is a miscalculation of the product, USD 50,000 ignores frequency, and USD 2,500 divides instead of multiplying.

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