Integrating internal and external loss data via an equivalence principle

Ruben D Cohen, Jia Lu and Jonathan Humphries

Abstract

An approach is presented to address the common and troublesome issue of data scarcity in operational risk analysis and modeling. The method uses external loss data to supplement internal loss data and operates by combining the two data sets via a principle of equivalence, linking the loss count with the time horizon through the loss frequency. Application of the principle, as described, leads to a merger between internal and external loss data, with implications for enabling the longer-term loss projections needed for scenario analysis, capital planning and stress testing. All this is accomplished in a rational and transparent way, without having to go through the conventional modeling procedures of writing complicated code to fit data into distributions and performing numerical computations and simulations.