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Quantitative Methods & Applications

BUS 200 Introduction to Risk Management and Insurance Fall 2008 Jin Park


Probability Distribution Application in Risk Management & Insurance Insurance Premium Using Probabilistic Approach

Probability Distribution

Representations of all possible events along with their associated probabilities Example;
Total number of points rolled with a pair of dice.

Outcome 2 3 4

Probability 1/36 2/36 3/36

6 7 8

5/36 6/36 5/36

10 11 12

3/36 2/36 1/36

Different Events

Mutually exclusive (events)

The probability of two mutually exclusive events occurring at the same time is ____ .

Collectively exhaustive (events) Independent (events)

Probability Distribution

Measure of central tendency

Measure of variability (risk)

Mean, Median, Mode

Difference (Min, Max) Variance Standard deviation Coefficient of variation

Unitless measure

Probability Distribution


B Mean A, B

Mean A

Mean B

Exercise 1

Article: Mom wins dream house

Number of tickets Chances of winning Price of a ticket Total proceeds Total payouts

Exercise 2

Article: Cadillac Escalade tops with car thieves.

Severity per insured Escalade Theft frequency Severity per theft

Insurance Premium

Gross premium
= Pure premium + Risk charge + Other loadings Pure premium = Expected Loss (EL)
= Expected Frequency x Expected Severity Estimated amount to pay for expected loss.

Risk charge (Risk loading)

Amount to cover the risk that actual loss may be higher than expected loss Expenses and profits

Other Loadings

Risk Charge (Risk Loading)

What determines the size/magnitude of the risk charge?

Amount of available past information to estimate EL The level of confidence in the estimated EL.

The number of loss exposures insured by the insurer The size of loss exposures

The higher the level of confidence in the estimated EL, the _____ the risk charge.

Risk charge for terrorism coverage would be _______ than that for personal automobile insurance.

Probabilistic Risk Analysis

Simple example of event tree
Early Detection Sprinklers Work?
No (.01) No (.10)

Fire stop Probability OK?

No (.001) Yes (.999)

Loss $100 mil


.000999 $10 mil .099 .90 $100 K 0

Yes (.90)

Yes (.99)

What is the expected severity of a fire?


Probabilistic Risk Analysis

What if there is no sprinkler system
Early Detection Fire stop Probability OK?
No (.001) No (.10)

Loss $100 mil


Yes (.90)

Yes (.999)

.0999 .90

$10 mil 0

What is the expected severity of a fire?