Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 47 Table 6: Comparison of Three Methods for Deriving Economic Capital Methodology Description Advantages Disadvantages Assumption Simple Sum Derive economic capital for credit, market, and operative risk and then sum them. Easy to implement. Most conservative view of risk. Overestimates risk. Results in the lowest level of capital adequacy. Correlation is assumed to be perfect among risk components. Modern Portfolio Theory From historical data, determine an explicit correlation among credit, market, and operative risk economic capital. Attempts to represent the actual correlation among risks rather than a conservative assumption. Requires a time series of market, credit, and operative risk economic capital that is reasonably robust. Assumes that some risks are uncorrelated, allowing for lower risk and improved capital adequacy. Monte Carlo Simulation Using consistent parameters, simulate risk factors to produce a joint distribution of outcomes. The most robust perspective of risks and their interaction if modeled correctly. Requires a large amount of research, analytical, and technological resources and ensuring that assumptions are correct is critical. Material risk inputs can be parameterized accurately. It should be clear which methodology was selected as well as the advantages and disadvantages. This discussion would most likely include the target confidence level and associated confidence level, the risk horizon or time horizon used in the analysis, and price propagation process used for market and credit risk. Any other relevant assumptions that have a significant effect on the analysis may also be included. 7.5 External Perspectives Because the capital adequacy business practices are emerging, the CCRO is postponing any discussion about disclosure, leaving it open for a second phase of the disclosure white paper. However, certain financial firms, insurers/reinsurers, and banks’ annual reports may provide a blueprint for future disclosure of capital adequacy by energy companies. Several annual reports from banking provide specific examples of economic capital disclosure and discussion. Table 7 is an example derived from these reports.