Chapter 4: Risk Measurement

Frequency and severity of losses Probability Probability distribution Fault tree Pooling arrangement and diversification of risk

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Learning Objective
Review the concepts of probability and statistics Apply mathematical concepts to understand the frequency and severity of losses Understand the concepts of expected value and variance of random variables Distinguish between binomial distribution and poisson distribution, and which is more appropriate for different situations Show how pooling of independent loss exposures reduces risk
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RISK MEASUREMENT

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Random Variables & Probability Distribution

RV is a variable which outcome is uncertain. Example: Flipping a coin. BINOMIAL DISTRIBUTION Each flips result is uncertain.

Probability Distribution identifies all of the PROBABILITY TREE possible outcomes, associates a DIAGRAM probability with each outcome.

POISSON DISTRIBUTION

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Possible Outcomes for Damages ( ) RM0

Probability 0.50

2
3 4 5

RM500
RM1,000 BINOMIAL RM5,000 DISTRIBUTION RM10,000 POISSON DISTRIBUTION Probability

0.30
0.10 0.06 0.04

The question now

0.6 0.5

How we make decision based on these data? Use 0.4 Expected Value 0.3 Variance or Standard Deviation 0.2 Skewness Correlation 0.1
0 RM0 RM500

Probability

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RM1,000

RM5,000

RM10,000

Expected Value
it is where the outcomes tend to occur, on average. , =
=1

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Expected Value
B A

Probability

Outcome
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Variance & Standard Deviation

Variance

=1

Standard Deviation

=1
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Expected Value
A

Probability

Outcome
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Expected Value & Skew

Probability

Outcome
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Maximum Probable Loss Vs Probable Maximum Loss

MPL : Worst loss in worst scenario

PML: Worst loss in normal scenario

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Maximum Probable Loss (Value At Risk)

Probability

area= 0.05

Area = 0.01

Annual Liability Loss

RM20m

RM30m
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Value at Risk
Monthly change in value of portfolio

Probability

Area: 0.05 Area: 0.01

-RM7.5m

-RM5m

0
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Correlation
When discussing about many types of risk, it is important to study the relationship among random variables. Correlation = 0 the random variables are not related. :: outcome of one random variables will not give info about the other random variables. :: random variables are said to be independent or uncorrelated.
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INDEPENDENT EVENTS

MUTUALLY EXCLUSIVE EVENTS

COLLECTIVE EXHAUSTED EVENTS

REVISION

ALTERNATIVE EVENTS

JOINT EVENTS

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 Basic Idea:
Issues:

Pooling Arrangements and Diversification of Risk

Replace your loss with the average loss of a group

What happens to each persons

Expected loss Standard deviation of loss Maximum probable loss

How do these results change with

More participants Correlation in losses among the participants increases

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Uncorrelated Risk Pooling Example with 2 People

Two people with same distribution (w/o pooling)
Outcome $2,500 Probability 0.20
0.80

Loss =
$0

Assume losses are uncorrelated

Expected value = Standard deviation =

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Uncorrelated Risk Pooling Example with 2 People

Two people with same distribution (w/o pooling)
Outcome $2,500 Probability 0.20
0.80

Loss =
$0

Assume losses are uncorrelated

Expected value = 2500 0.2 + 0 0.8 = $500 Standard deviation = 2500 500 2 0.2 + 0 500 2 0.8 = $1000
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Uncorrelated Risk Pooling Example with 2 People

Tree Diagram 0.2 Loss 0.2 0.8 No Loss Loss 2500 / 2 = 1250 2500 / 2 = 1250 Loss Loss Amount to be shared 2500 x 2/2 = 2500

0.8 No Loss

0.2

0.8

No Loss

0
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Uncorrelated Risk Pooling Example with 2 People

Pooling Arrangement changes distribution of accident costs for each individual
Outcome Probability

$0

Cost = 1,250
2,500 Expected Cost = SD =
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Uncorrelated Risk Pooling Example with 2 People

Pooling Arrangement changes distribution of accident costs for each individual
Outcome Probability

$0

0.64

Cost = 1,250
2,500 Expected Cost = $500 SD = $707

0.32
0.04

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Risk Pooling Example with 2 People

Effect on Expected Loss
w/o pooling, expected loss = $500 with pooling, expected loss = $500

Effect on Standard Deviation

w/o pooling, standard. deviation = $1,000
with pooling, standard. deviation = $707
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Risk Pooling Example with More People

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The Effect of Risk Pooling Arrangements on Probability Distributions for a large number of small business

Probability Distributions

With Pooling

Without Pooling

20000

40000
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60000
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Cost paid by each business

Risk Pooling of Uncorrelated Losses

Main Points:
Pooling arrangements
do not change expected loss reduce uncertainty (variance decreases, losses become more predictable, maximum probable loss declines) distribution of costs becomes more symmetric (less skewness)

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Effect of positive correlation on Risk Reduction

Probability Distributions

Uncorrelated

Positive Correlated

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Effect of positive correlation on Risk Reduction

Standard Deviation of Average Loss

Perfect Correlation

Less than perfect correlation

Uncorrelated

Number of participants in risk pooling BWRR3033_Rodziah(c)

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RISK MEASUREMENT (Analyze)

DEFINITION (What?) LOSS FREQUENCY ESTIMATION (How) nil/ slight/ moderate/ ultimate Very likely/ likely/ unlikely Critical/ important/ unimportant fatal,/ major/ minor/ negligible

Number of times loss occurs

during a specific time on record.

LOSS SEVERITY

Size of loss per occurrences.

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RISK MEASUREMENT (Evaluate)

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