INTRODUCTION TO RISK & INSURANCE

Self Assessment - Problems

P1 [1.4]

Consider a set of 3 transactions, with random results

X1 , X2 , X3
The outcome for each transaction depends on which state of the world occurs, out of a set
of 4 states
S1 , S2 , S3 , S4
Assume
P[S1 ] = P[S2 ] = P[S3 ] = P[S4 ] = 0.25
and the following payoff matrix:

S1 S2 S3 S4

X1 1 10 10 20
X2 9 10 10 10
X3 10 2 18 30

Discuss the choice, also allowing for the variance of the results.

P2 [1.4]

Consider two zero-coupon bonds whose payoffs at maturity (time 1, assuming the year as the
time unit) are as follows:

S1 S2

XA 1000 1000
XB 800 1200

where S1 and S2 denote two states of the world, each one with natural probability p = 12 .
Let PA , PB denote the prices of the bonds. Assume rf = 0.03 as the risk-free rate.
Questions:
1. provide an example of PB consistent with risk-aversion;
2. for a given value of PB , calculate
(a) the related risk premium
(b) the risk-adjusted probabilities of S1 and S2

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P3 [1.4]

An individual, during the last five years of her/his working period, accumulates in a fund
which will be available at retirement time.
Assume that:

I. at the beginning of each year, and thus for five times, the (constant) amount 1000 is
paid to the fund;

II. the interest rate in the accumulation process is i = 0.03.

Questions:

1. Calculate the amount S resulting at the end of the accumulation, i.e. at time 5.

2. Assume that, at time 3, the individual decides to achieve the amount 1.10 S instead of
S. To this purpose, she/he decides to pay, at time 3 only, an amount higher than 1000.
What is the amount required ?

P4 [1.4]

A cargo can be damaged during transport. Let X denote the random amount of the damage.
Assume for X the following possible outcomes:

0, 100, 200, 300, 400, 500

Note that X = 0 means that no accident occurs. Questions:

1. Assign a probability distribution to the possible outcomes of X.

2. Calculate, assuming the probability distribution specified above,

(a) the expected value of the damage, E[X];

(b) the variance of the damage Var[X], and its standard deviation [X];
(c) the expected value of the loss conditional that an accident occurs, x = E[X | E].

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P5 [1.4]

An employer takes the risk of paying to the employees a lump-sum benefit in the case of
permanent disability due to an accident.
Assume that:

I. the time horizon is one year;

II. 120 employees are exposed to the risk of accident;

III. for each employee, the amount of the benefit is 1000 monetary units;

IV. for each employee, the probability of an accident is p = 0.002.

Questions:

1. what are the possible outcomes of the employers total payout X ?

2. what is the expected value, E[X], of the total payout ?

3. what hypothesis is required in order to adopt a simple formula for the variance, Var[X],
of the total payout ?

4. calculate Var[X] assuming the hypothesis declared in the previous answer.

P6 [1.4]

An industrial building can be damaged by fire, once or more times during a one-year period.
In each occurrence, the amount of the damage is a random variable Xk , k = 1, 2, . . . .
Denote with N the random number of occurrences; assume as the possible outcomes:

0, 1, 2, 3, 4, 5

with the following probabilities h = P[N = h]:

0 = 0.98; 1 = 0.01; 2 = 0.004; 3 = 0.003; 4 = 0.002; 5 = 0.001

Questions:

1. calculate the expected number of occurrences, E[N ];

2. assuming that all the random variables Xk s have the same expected value, namely

E[X1 ] = E[X2 ] = = 1000

and assuming that N and the Xk s are independent, what can you say about the expected
value, E[X], of the total damage over the year ?

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P7 [1.6]

Assume that 150 individuals bear the same tipe of basic risk, and constitute a pool. The
individual random loss, X (j) , for j = 1, 2, . . . , 150, is defined as follows:
(
x(j) if E (j)
X (j) = (j)
0 if E

where E (j) is the event causing the loss to individual j. The events E (j) are assumed to be
independent each other. Further, assume that the pool is homogeneous in terms of both the
amounts and the probabilities of loss; thus, for j = 1, 2, . . . , 150:

x(j) = 1000

p(j) = 0.003
Denote with X [P] the total payout from the pool, namely
150
X
[P]
X = X (j)
j=1

Questions:

1. calculate the expected value and the variance of the individual loss, namely E[X (j) ] and
Var[X (j) ];

2. what are the possible outcomes of the total payout X [P] ?

3. calculate

(a) the expected value E[X [P] ];

(b) the variance Var[X [P] ];
(c) the coefficient of variation CV[X [P] ].

P8 [1.6]

Refer to a pool of n = 1000 independent risks, homogeneous in terms of losses and individual
probability of loss.
Assume that the coefficient of variation of the total payout X [P] is CV[X [P] ] = 2.
Questions:

1. what can you say about the coefficient of variation if the pool consists of 4n = 4000
risks ?
n
2. and if the pool consists of = 500 risks ?
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P9 [1.6]

Refer to a pool of n = 500 independent risks, homogeneous in terms of both the amount of
individual loss x = 100 and the probability of loss p = 0.01.
Assume that the total random payment X [P] is to be shared equally among the members of
the pool.
Questions:

1. calculate the expected value of the amount contributed by each member;

2. calculate the variance of the amount contributed by each member.

Further,

3. what can you say about the expected value and the variance of the amount contributed
by each member if the pool consists of 1000 members (instead of 500)?

P10 [1.6]

A mutual benefit society consists of 500 members. At the beginning of a given period, each
member pays a contribution of 100 monetary units. Each member is exposed to the risk of a
loss of 10000 monetary units.
Questions:

1. What is the benefit received, at the end of the period, by each member who suffered a
loss, if

(a) the total number of losses is 4;

(b) the total number of losses is 10.

2. In the case (a), how can be used the result produced at the end of the period ?

P11 [1.7]

An insurance product covers the risk of a possible loss with a fixed amount.
Assume that the amount of the loss is 100000 monetary units, and the probability is p = 0.005.
Questions:

1. calculate the premium P according to the equivalence principle (and disregarding the
time-value of the money);

2. to calculate the premium , assume a safety loading of 60 monetary units; find the
adjusted probability of loss implied by the loading itself.

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P12 [1.7]

An insurer sells a 3-years term assurance; the insured is age 45 at the policy issue. Let
C = 1000 be the benefit.
The premium is calculated by assuming, as the first order basis, the annual rate of interest
i0 = 0.03 and the following probabilities of death:
0 0 0
0|1 q45 = 0.0027; 1|1 q45 = 0.0030; 2|1 q45 = 0.0035

The estimated yield from the insurers investment is i = 0.04, and the realistic probabilities
of death are:
0|1 q45 = 0.0020; 1|1 q45 = 0.0023; 2|1 q45 = 0.0030

Questions:

1. calculate the premium ;

2. calculate the expected profit (if is the premium adopted).

P13 [1.7]

An insurer sells a pure endowment product, with maturity at time r = 10. Let S = 1000 be
the benefit.
The premium is calculated by assuming, as the first order basis, the annual rate of interest
i0 = 0.02 and the survival probability p0 = 0.95.
The estimated yield from the insurers investment is i = 0.05, and the realistic survival prob-
ability is p = 0.97 (second order basis).
Questions:

1. calculate the premium ;

2. calculate the expected profit (if is the premium adopted).

Further,

3. for i, p and p0 as given above, find the maximum interest rate i0 implying a non-negative
expected profit (and hence compensating the spread p p0 )

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P14 [2.2]

An insurer sells a basic insurance cover (sum insured = amount of loss) for risks with a sum
insured of 10000 monetary units and claim probabilities p1 = 0.003, p2 = 0.006.
Assume the following portfolio structure:

I. n1 = 1000 risks, with claim probability p1

II. n2 = 2000 risks, with claim probability p2

Questions:

1. assume that the insurer applies to all the risks the same premium rate; calculate the
equilibrium premium rate p;

2. assume that the insurer applies two premium rates, p1 and p2 , fulfilling the constraints

p1 < p1 < p2 < p2

provide an example of equilibrium premium rates p1 and p2 .

P15 [2.2]

An insurer sells a basic insurance cover (sum insured = amount of loss) for risks with claim
probability p1 = 0.002 and risks with claim probability p2 = 0.005. The insurer applies to all
the risks the premium rate p = 0.003.
Assuming for all risks a sum insured of 10000 monetary units, calculate the expected result
in the following cases:

1. the portfolio consists of 500 risks with probability p1 and 1000 risks with probability p2 ;

2. the portfolio consists of 1000 risks with probability p1 and 500 risks with probability p2 ;

3. the portfolio consists of 1500 risks, all with probability p2 .

Further questions:

4. in the case 1 above, what premium rate (the same for all risks) should be applied to
achieve the equilibrium at the portfolio level ?

5. in the case 2 above, what premium rate (the same for all risks) should be applied to
achieve the equilibrium at the portfolio level if the first 1000 risks have 10000 as the sum
insured whereas the remaining 500 have 20000 as the sum insured ?

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P16 [2.2]

An insurer sells a basic insurance cover (sum insured = amount of loss).

Risks can be split into three risk classes, with claim probabilities

I. p1 = 0.001

II. p2 = 0.002

III. p3 = 0.005

In order to simplify the rating system, the insurer adopts two rating classes only. What choices
can be considered as reasonable (namely, such as to avoid a too strong adverse selection) ?

P17 [2.2]

An insurer sells a basic insurance cover (sum insured = amount of loss), for risks with claim
probability p1 = 0.001 and risks with claim probability p2 = 0.003. The insurer applies to all
the risks the premium rate p = 0.002.
Questions:

1. assume for all the risks a sum insured of 100 monetary units; what are the portfolio
structures leading to equilibrium (that is, expected profit = 0) ?

2. suppose that some risks have a sum insured of 100 monetary units, while other risks
have a sum insured of 200 monetary units; provide an example of portfolio structure
leading to equilibrium.

P18 [2.3]

An insurer sells a basic insurance cover (sum insured = amount of loss). The portfolio
consists of

1000 policies with sum insured 100;

500 policies with sum insured 400.

Questions:

1. calculate

(a) the average sum insured and the variance of sums insured
(b) the variance of the sums insured

2. assuming that the claim probability is p = 0.002 for all the policies, calculate the ex-
pected total payout

3. assuming further that the risks are independent, calculate

(a) the variance of the total payment

(b) the standard deviation of the total payment

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P19 [2.3]

An insurer sells a basic insurance cover (sum insured = amount of loss), for independent
risks, all with claim probability p = 0.01.
Assume that:

I. all the risks have a sum insured of 1000 monetary units;

II. the portfolio consists of 200 risks.

Questions:

1. calculate the risk index for this portfolio;

2. what about the risk index if

(a) the portfolio consists of 2000 risks ?

(b) the portfolio consists of 20000 risks ?

3. what about the risk index if the portfolio consists of 200 risks all with 2000 monetary
units as the sum insured ?

P20 [2.3]

An insurer sells a basic insurance cover (sum insured = amount of loss), for independent
risks, all with claim probability p = 0.005.
Calculate the risk index for the following three portfolios:

1. 500 risks with a sum insured of 100, and 500 risks with a sum insured of 200;

2. 1000 risks with a sum insured of 150, and 100 risks with a sum insured of 480;

3. 1500 risks all with a sum insured of 200.

Comment on the relevant results.

P21 [2.3]

Assume that, in a given portfolio, the amount

M + m[P] = 22000

is required, in order to obtain a stated ruin probability (for example, 0.5%).

If the cost of shareholders capital is r = 0.10, what values of M leads to creation of value ?

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P22 [2.4]

In a Stop-Loss reinsurance arrangement, the following conditions are stated:

priority = 10000

upper limit = 25000

Calculate the reinsurers payment X [ced] in the following cases (expressed in terms of the
cedants total payout before reinsurance):

1. X [P] = 12000

2. X [P] = 8000

3. X [P] = 36000

4. X [P] = 30000

P23 [2.4]

An insurer sells a basic insurance cover (sum insured = amount of loss), for risks all with
claim probability p = 0.005.
The portfolio consists of

1000 policies with sum insured 500;

3000 policies with sum insured 1000;

100 policies with sum insured 4000.

The safety loading is equal to 10% of the equivalence premium.

Assume that, according to the reinsurance arrangement, the safety loading is shared between
the cedant and the reinsurer in the same proportion of the sums insured.
Questions:

1. what is the amount of expected profit retained in a surplus reinsurance arrangement

with the retained line x[ret] = 800 ?

2. what is the amount of expected profit retained in a quota-share arrangement with the
retention share a = 0.70 ?

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P24 [2.4]

Refer to a portfolio of basic insurance covers (sum insured = amount of loss), for independent
risks all with claim probability p = 0.01.
The portfolio consists of

1000 policies with sum insured 1000;

500 policies with sum insured 2000.

Questions.

1. Calculate

(a) the expected value

(b) the variance
(c) the standard deviation

of the total portfolio payout

2. Assume a quota-share reinsurance, with the retention share a = 0.80; calculate

(a) the expected value

(b) the variance
(c) the standard deviation

of the retained portfolio payout

3. Assume a surplus reinsurance, with the retention line x[ret] = 1200; calculate

(a) the expected value

(b) the variance
(c) the standard deviation

of the retained portfolio payout

Comment on the relevant results.

P25 [2.5]

In an Excess-of-Loss (XL) reinsurance arrangement, assume = 1000 as the deductible

(whereas no upper limit is stated).
Referring to various claims Xk , calculate the reinsurers intervention, in absolute and relative
terms, for

1. X1 = 1250

2. X2 = 800

3. X3 = 2000

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P26 [2.5]

Refer to Cat XL arrangements.

1. The arrangement is defined on a claim-number basis; hence

( )
[ret] k [ret]
X = min X, X
K

where K denotes the random number of claims, and X the total payout (before reinsur-
ance). Assume k [ret] = 10. What is the retained payout, X [ret] , if
(a) K = 15, X = 9000
(b) K = 9, X = 12000
2. The arrangement is defined on a total-amount basis; thus
n o
X [ret] = min X, x[ret]

Assume x[ret] = 10000. What is the retained payout, X [ret] , in case (a) and case (b)
respectively ?

P27 [2.5]

Refer to a portfolio which is protected by an Excess-of-Loss (XL) reinsurance arrangement;

the following limitations are stated:
the deductible is = 1500;
the 1st layer upper limit is 2 ;
the 2nd layer upper limit is 4 .
Describe the sharing of the following claims:
1. X1 = 1000
2. X2 = 2600
3. X3 = 5000
4. X4 = 8000

P28 [2.5]

A reinsurance program consists of a quota-share with retention share a = 0.80, combined with
a surplus arrangement with retained line x[ret] = 1000.
Assume that the first risk in the portfolio has x(1) = 1500 as the sum insured. Find the
retention for this risk if
1. first the quota-share reinsurance is applied, then the surplus;
2. first the surplus reinsurance is applied, then the quota-share.

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