The Quantitative Modeling of Operational Risk: Between G-and-H and EVT

Matthias Degen, Paul Embrechts, Dominik D. Lambrigger

Astin Bulletin · 2007 · 129 citations · 21 references

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TL;DR

Operational risk has become a critical component in banking and insurance, yet limited data sets have only recently allowed researchers to propose models such as the parametric g‑and‑h distribution. The paper investigates fundamental properties of the g‑and‑h distribution, its link to extreme value theory, the subadditivity of Value‑at‑Risk for high quantiles, and its application in a one‑claim‑causes‑ruin framework. The authors analyze the g‑and‑h distribution’s characteristics, its slow convergence to the generalized Pareto distribution, and its behavior within a one‑claim‑causes‑ruin model. They find that excess‑distribution convergence to the GPD is extremely slow, leading to inaccurate EVT‑based quantile estimates, and that Value‑at‑Risk can become superadditive for high quantiles under realistic g and h parameters.

Abstract

Operational risk has become an important risk component in the banking and insurance world. The availability of (few) reasonable data sets has given some authors the opportunity to analyze operational risk data and to propose different models for quantification. As proposed in Dutta and Perry [12], the parametric g-and-h distribution has recently emerged as an interesting candidate. In our paper, we discuss some fundamental properties of the g-and-h distribution and their link to extreme value theory (EVT). We show that for the g-and-h distribution, convergence of the excess distribution to the generalized Pareto distribution (GPD) is extremely slow and therefore quantile estimation using EVT may lead to inaccurate results if data are well modeled by a g-and-h distribution. We further discuss the subadditivity property of Value-at-Risk (VaR) for g-and-h random variables and show that for reasonable g and h parameter values, superadditivity may appear when estimating high quantiles. Finally, we look at the g-and-h distribution in the one-claim-causes-ruin paradigm.

References

21