Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 38 • Risk classes (people, processes, systems, asset damages) – the broadest classes of risks • Subcategories – could include whether the risk is internal or external, a type of fraud, or a natural disaster • Risk activity examples – specific activities or events that could cause a loss, such as rogue trading, hurricane, model risk, or pipeline rupture. Other types of information may be included in the taxonomy, depending on the needs of the practitioner: • High-frequency, low-impact (HFLI) versus low-frequency high-impact (LFHI) distinction – important for determining what risks are “capital risks” and which are “cost risks” • Mitigation technique – inclusion of the specific type of insurance or financial protection, which may be obtained to offset the effects of a loss brought on by a specific risk activity, such as property and casualty or directors and officers insurance • Legal risks – discussion of any legal liability resulting from a loss event • Operations risks – given the uniqueness of operations risks, it may be preferable to provide additional sorting criteria within the taxonomy. These different concepts act as filters for the data used to measure operative risk, serving as a template for aggregation, organization, and analysis. This filtering is important, since the wide range of risks included under the banner of “operative” can become untenable if a robust organizational framework is not imposed on them. Beyond the taxonomy discussed above, it is important to focus on economic capital adequacy and its relationship with operative risk. The following are important for clarifying this relationship: • Discussion of the diversity of asset businesses and thus operations risks among member companies • Discussion of HFLI events and LFHI events and how they relate to capital needs. HFLI is usually a cost-based issue, whereas LFHI can be a capital issue. In banking, LFHI events are considered to be uncorrelated to other risk classes such as credit and market, but in energy, the operative risk from assets is often highly correlated with market events and hence with market and credit risks. HFLI events may not be capital issues, but they should not be ignored, as they can be indicative of poor controls that could lead to a LFHI event. • Discussion of risk in terms of a causality chain, specifically, how to organize risk data as events and effects. 6.3 Operative Risk Measurement Techniques Practices for measuring operational risk are highly developed in some industries and virtually non- existent in others. Companies must at the very least consider aggregating these risk factors in some