Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 44 simulation methodologies available for market and credit risks be disregarded in order for the combined capital need to be consistent? This issue is closely linked to the incentives for effective risk management. The choice of methodology should not penalize successful risk mitigations. 7.2 Input Parameters When combining market, credit, and operative risk, we must ensure that the risk or time horizon of the analysis is harmonized. The CCRO advocates the one-year time horizon because the business planning cycle typically has an annual perspective and cycle. In addition, default probabilities are typically measured annually. Adhering to a one-year time horizon standard also permits comparisons across the industry. Note that we are measuring the value of a portfolio of assets and liabilities for its entire life, not just the first year. By combining economic capital for market, credit, operations, and operational risk, we are attempting to measure the change in the value of the company’s portfolio and its components. The amount of the change in value should be consistent with an amount applicable to a one year-change in the inputs and assumptions. Economic capital can be calculated for risk horizons shorter or longer than one year. Depending on the desired risk profile, more conservative companies can choose a longer time horizon to provide a larger risk cushion. This may provide valuable insight for senior managers and external stakeholders however, precision in a capital adequacy measure may be reduced beyond one year because of issues associated with simulating or modeling the behavior of commodity prices over very long periods of time. In addition to the risk horizon, a consistent target confidence level must be used for market, credit, and operational/operations risk. This is particularly important for the simple methodologies for combining economic capital measures. A consistent target confidence level equates to a consistent confidence level for the resultant statistical distributions16. The confidence level selected can be derived from the target credit rating and associated default probability determined to be applicable for the company. Ideally, a consistent level of sophistication should be used in determining market, credit, and operative risk. However, the relative level of model sophistication of market and credit risk probably differs from that of operative risk. While well known to insurers/reinsurers, operational risk is somewhat of an emerging risk concept, and this is especially true for energy companies’ efforts in building an integrated risk management framework. Therefore, we can expect to see a certain degree of disparity in sophistication between operative and market/credit risk. 7.3 Proposed Methodological Solutions The CCRO has identified three methodologies for combining market, credit, and operational/operations risk analysis. The particular methodology an organization selects depends on the level of sophistication of the methodology chosen for the individual risk components. Therefore, if the individual components are estimated with analytical solutions, a methodology of similar sophistication should be used for total economic capital. The methodologies vary from 16 However, mathematically, it is likely that the confidence level chosen at the individual distribution level does not equal the confidence level of the joint distribution of all risks.