Chapter

Risk Measurement & Risk Pooling

 Probability Distribution
Possible Result Probability
from FIN 410
A 0.6
A- 0.2
B+ 0.15
B 0.05
 Probability Distribution of Pure Risk
Mr. Rony has purchased a new car from which he is
facing a risk that his car may face accident on road. He
has identifies the following possible loss amounts from
the accident
Possible Loss Amount Probability
Tk 0 0.3
5,000 0.4
10,000 0.2
50,000 0.1
 Characteristics of Probability
Distribution
• Expected Value
• Standard Deviation
• Sample Mean and Variance
• Correlation
• Skewness
 Expected Value
Possible Loss Probability (P) xP
Amount (x)
0 0.4 0x 0.4 = 0

3000 0.6 3000 x 0.6 =

1800
Expected 1800
Value, x
 Standard Deviation
• =
 Standard Deviation
Loss (x) Prob (P) _ _ _
x–x (x - x)^2 P (x – x) ^2

0 0.4 0- 1800 = -1800 (-1800)^2= 0.4x3240,000=

3240000 1296000

3000 0.6 3000-1800 = (1200)^2= 0.6x 1440,000=

1200 1440000 864,000

2160000

𝜎 = √ 2160000=1469.69
 Correlation
• r value ranges from -1 to +1

-1 0 +1
Strong Negative No Relation Strong
• Positive

0 0.2 0.4 +1
• Risk is Minimum Risk is Maximum
 Strong Positive Correlation, r=+1
Strong Negative Correlation, r= -1
X Y X Y
5% ↑ 5% ↑ 5% ↑ 5% ↓
10% ↑ 10% ↑

8% ↓ 8% ↓ 8% ↓ 8% ↑
• Normal Distribution/ Bell Shaped Curve
• Skewness= 0 Risk is Minimum

• Mean Value
• Right Skewed Left Skewed
• Existence of Skewness
• High Risk
 Pooling
• Distributing loss faced by one member among
all the pooling members.

• Rahim Textile and Sinha Textile, both are

renowned textile factory of the country. Both
these two companies face the risk of having a
fire incident at their factory. They face the
same probability distribution.
 Before Pooling
Possible
Loss (x)
Probabilit
y (p) xP (x-x)

0 0.4 0 x 0.4 = 0 0 – 1200 = 0.4 x 1440000=

-1200 576,000

2000 0.6 2000 x 0.6= 2000 – 1200 = 640000 0.6 x 640000 =

1200 = 800 384,000

60,000
x = 1200

𝜎 = √ 960,000= 979.79
 After Pooling Probability Distribution
Rahim Sinha Total Loss Contribution by Each Probability (P)
Member (x)

0 0 0 0 0.4 x 0.4 = 0.16

0 2000 2000 2000/2 = 1000 0.4 x 0.6 = 0.24

2000 0 2000 2000/2 = 1000 0.6 x 0.4 = 0.24

2000 2000 4000 4000/2 = 2000 0.6x 0.6 = 0.36

 After Pooling Standard Deviation
Possible Probability xP (x- x) (x – x) 2 P (x – x) 2
Loss (x) (P)

0 0.16 0 x 0.16= 0 -1200 1440000 230,400

1000 0.48 1000 x -200 40000 19,200

0.48= 480

2000 0.36 2000 x 800 640000 230,400

0.36 = 720

x = 1200 480,000

692.82
• Before Pooling, Risk for each factory= Tk 979

• After Pooling, Risk for each factory = 692

 Member Number & Risk

𝜎
20 100 No of Members
 Consideration of Correlation on After
Pooling Risk
• σ r = +1

0<r<1

• r=0
• No of members
 Before Pooling for X & Y
Possible Loss Probability (P)
Amount (x)
Tk 0 0.3
500 0.5
1000 0.2
X Y Total Loss Loss Probability (P)
Contributed by
Each Member
(x)
0 0 0 0 0.09
0 500 500 250 0.3x0.5= 0.15
0 1000 1000 500 0.3x0.2= 0.06
500 0 500 250 0.5x0.3= 0.15
500 500 1000 500 0.25
500 1000 1500 750 0.5x0.2= 0.10
1000 0 1000 500 0.06
1000 500 1500 750 0.2x0.5 = 0.10
1000 1000 2000 1000 0.04
Possible Loss Amount (x) Probability (P)
0 0.09
250 (0.15+ 0.15) = 0.3
500 (0.06 +0.06+ 0.25) = 0.37
750 (0.1 +0.1) = 0.2
1000 0.04
 Cost of Pooling
• Distribution Cost
• Underwriting Cost
• Claim Settlement Cost
• Collection Cost
• Ex Post Payment
• Ex-Ante Payment