LO 43.3: Explain how Monte Carlo simulation can be used to generate additional

LO 43.3: Explain how Monte Carlo simulation can be used to generate additional data points to estimate the 99.9th percentile of an operational loss distribution.
Once the frequency and severity distributions have been established, the next step is to combine them to generate data points that better estimate the capital required. This is done to ensure that likely losses for the next year will be covered at the 99.9% confidence level. Monte Carlo simulation can be used to combine frequency and severity distributions (a process known as convolution) in order to produce additional data points with the same characteristics as the observed data points.
With this process, we make random draws from the loss frequency data and then draw those events from the loss severity data. Each combination of frequency and severity becomes a potential loss event in our loss distribution. This process is continued several thousand times to create the potential loss distribution. To find the 99.9% confidence level, with a million observations for example, we would select the 1,000th item in an ordered list (from largest to smallest loss) to represent the maximum loss that will be experienced in a single year with 99.9% certainty.
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