BBMF2083 INSURANCE MANAGEMENT

CHAPTER 2 RISK ASSESSMENT, POOLING & DIVERSIFICATION (ANSWERS)

1.

a) Show the physical damage loss distribution for Scary Airline’s planes.

Loss Outcome Probability Size of loss

Crash 1/10,000,000 $50,000,000
No Crash 9,999,999/10,000,000 $0

b) Calculate the expected value of the physical damage loss.

Expected value = 1/10,000,000 * $50,000,000 + 9,999,999/10,000,000 * $0 = $5

c) Show the calculations for the variance and the standard deviation.

Loss Loss outcome – (Loss outcome – (Loss outcome – expected

outcome Probability expected loss expected loss)2 loss)2 * Probability
$0 0.9999999 –5 25 24.9999975
$50,000,000 0.0000001 49,999,995 2.4999,995 x 1015 249,999,950
Variance = 249,999,975
So standard deviation = square root of variance = $15,811.39

2.

a) Use the information in the table to find the average frequency of losses per worker.

Ave. Frequency = 200 claims/1,000 workers = 0.2 claims per worker

b) Use the information in the table to estimate a probability distribution for the
frequency distribution of losses per worker in a year.

No. of claims 0 1 2
Probability 0.85 0.1 0.05

c) Use the information in the table to find the average severity per claim.

Ave. Severity = total losses paid/no. of claims = $300,000/200 claims = $1,500/claim

d) Use the information in the table to estimate a probability distribution for the loss
severity per claim.

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Midpoint of claims range 1,000 6,000
Probability 0.9 0.1

e) Using your answers from Question 2 (b) and (d), use convolution to find the average
loss.

Total loss
*
Ro Loss Total Probabilit probabilit Joint
w 1 Loss 2 loss y y probabilities
A — — 0 0.8500 0.0
B 1,000 — 1,000 0.0900 90.0 0.1*0.9
C 6,000 — 6,000 0.0100 60.0 0.1*0.1
E 1,000 1,000 2,000 0.0405 81.0 0.05*0.9*0.9
F 1,000 6,000 7,000 0.0045 31.5 0.05*0.9*0.1
H 6,000 1,000 7,000 0.0045 31.5 0.05*0.1*0.9
I 6,000 6,000 12,000 0.0005 6.0 0.05*0.1*0.1
1.0000 300.0

3.
a) Calculate the expected value and standard deviation of Al’s losses for the year.

prob loss prob*loss

0.85 $0 0
0.10 20,000 2,000
0.05 40,000 2,000
$4,000 = expected value of loss

prob loss loss-mean (loss – exp. value)2 (loss–exp.

value)2*prob

0.85 $0 -4,000 16,000,000 13,600,000

0.10 20,000 16,000 256,000,000 25,600,000

0.05 40,000 36,000 1,296,000,000 64,800,000

Variance = 104,000,000
so standard deviation = square root of variance = $10,198.04

b) Assume that Al pools his losses with Ed’s store, which has an identical loss
distribution. Ed’s losses are independent of Al’s. Al and Ed agree to split the total
losses in the pool equally. Show the revised probability distribution for the mean loss
from the pool.

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Al’s Loss Ed’s Loss Total Loss Mean Loss Probability
0 0 0 0 0.85 x 0.85 = 0.7225
20000 0 20000 10000 0.10 x 0.85 = 0.085
40000 0 40000 20000 0.05 x 0.85 = 0.0425
0 20000 20000 10000 0.85 x 0.10 = 0.085
20000 20000 40000 20000 0.10 x 0.10 = 0.01
40000 20000 60000 30000 0.05 x 0.10 = 0.005
0 40000 40000 20000 0.85 x 0.05 = 0.425
20000 40000 60000 30000 0.10 x 0.05 = 0.005
40000 40000 80000 40000 0.05 x 0.05 = 0.0025

Mean Loss Probability

0 0.7225
10000 0.1700
20000 0.0950
30000 0.0100
40000 0.0025
1.0000

c) Calculate the expected value and standard deviation of the pooled mean losses.

prob loss prob*loss

0.7225 $0 0
0.17 10,000 1,700
0.095 20,000 1,900
0.01 30,000 300
0.0025 40,000 100
1.0 4,000 = expected value

prob loss (loss – exp. value)2 (loss–exp.

value)2*prob

0.7225 $0 16,000,000 1,1560,000

0.17 10,000 36,000,000 6,120,000

0.095 20,000 256,000,000 24,320,000

0.01 30,000 676,000,000 6,760,000

0.0025 40,000 1,296,000,000 3,240,000

1.0 52,000,000

so standard deviation equals $7,211.10 (square root of 52,000,000)

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4. Insurers combine a large number of exposure units in the process of risk pooling.
Describe the effect of increasing the size of the risk pool on the mean loss of the pool
and on the standard deviation of the mean loss in the pool. In your answer, assume
that the losses of all the exposure units in the pool are independent and homogeneous.

Increasing the size of the risk pool will have little effect on the mean loss of the pool. If
losses are random in a group of independent, homogeneous exposure units, then, as the
size of the pool increases, the standard deviation of the losses will decrease. This is the
classical application of the law of large numbers.

5. Describe the concept of a risk charge as the term is used in the

calculation of insurance premiums. Is the risk charge affected by an
increase in the number of exposure units in a risk pool?

Because there is deviation from the mean, an insurer charges a risk charge, in
essence a safety margin. As the number of exposure units increases, the standard
deviation decreases; hence, the risk charge decreases.

6. List and briefly describe two examples of loss exposures that are not
well suited to risk pooling, and explain the reasons why risk pooling is
not effective for these loss exposures.

Catastrophic exposures such as floods and earthquakes are not well suited to risk
pooling. These perils tend to strike a number of exposure units in a relatively
concentrated area at the same time. There is a high correlation between the loss
potential of one exposure unit and any other unit in the same geographical area.

7.
a) NPV = RM210,618 – RM175,000 = RM35,618

As the NPV is +ve, the project is acceptable.

b) IRR = 13.20% (> 6%) => Project is acceptable.

c) Both methods produce the same results, i.e. the project is acceptable.

8. PV (1st alternative) = RM368,004

PV (2nd alternative) = RM329,197

As GAG would like to minimise the PV of its cash outflows, the 2nd alternative is
preferred.