Hybrid Model Construction: Integration of ILD, ED and SA

Rafael Cavestany

Once the modelling of the four data elements has been performed, as presented in the last three chapters, we now look into the merger of these data elements into a hybrid model. The merger of data elements will result in a single loss severity distribution (or loss frequency distribution, if applied to frequencies) of the operational losses for the ORC incorporating different data elements.

Regarding the merger of different data elements, BCSG-AMA says, “A bank should carefully consider how the data elements are combined and used to ensure that the bank’s operational risk capital charge is commensurate with its level of risk exposure.”

This chapter presents credibility theory and various methods for merging the different data elements into a single loss or frequency distribution hybrid model, organised in the following sections:

• □

  “Credibility theory: determining the weights for ILD, ED and SA in the hybrid model”: In this section, we look at the different models for credibility theory that permit us to determine the weight of each data element within the hybrid model methods presented in this chapter.

• □

  “The mixture approach”: In this section, we present a