Professional Documents
Culture Documents
(A)
INTRODUCTION
After the broad range of risk exposures have been identified, the
financial impact of each risk must be estimated.
2 key statistical measures used to evaluate loss exposures:
1. Frequency of loss
2. Severity of loss
(B)
1. Random Variable
A variable whose future value is not known with certainty.
E.g. The number of auto accidents caused by the company
drivers, the amount of money owed to injured workers as a result
of workers compensation obligations, or the average loss in
revenue associated with an unexpected closure of 1 of the firms
retail outlets due to a fire.
Random factors can affect these measures. E.g. Highway driving
conditions, severity of worker injuries & effectiveness of a stores
fire sprinklers.
2. Probability Distributions
A table / graph that shows all possible outcomes for a random
variable & their respective probabilities of occurring.
E.g. The probability distributions for the number
that will result from a given roll of a die:
Value on die
Probability
RM0
RM100,000
3. Expected Value
Sum of the multiplication of each possible outcome of the variable
with its probability.
E[R] = Ri * Pi
E.g. Based on Ricks loss distribution, his expected loss is:
Expected loss =
An insurer would use the RM10,000 expected loss as a starting
point in calculating the premium that it needs to charge Rick to
insure his liability risk.
2 measures of risk:
a. Variance: Measures how the outcomes of a random variable vary
around the expected value of that variable.
b. Standard deviation: Square root of the variance.
R
i 1
E R * Pi
2
Variance =
Standard deviation =
(C)
E.g. Suppose that Rebecca, the risk manager for a large car rental
firm, wants to estimate the per-car average cost to repair damage
from collisions & other related causes of loss in her vehicle fleet for
the coming year.
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2. Average frequency
= No. of losses per car x Estimated probability
2. Average severity
= Amount of loss x Estimated probability
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(D)
CONVOLUTION
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Expected value
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In Table 3-4:
1. Row A: Probability of no loss occurring = 0.91 (refer frequency
distribution in Table 3-2)
2. Rows B, C & D: If only 1 loss occurs, there are 3 possible outcomes.
Joint probabilities
= Probability of each severity value (refer severity distribution in Table
3-3) x 0.08 (probability that loss frequency is 1 in Table 3-2)
3. Rows E to M: 2 losses occur.
Joint probabilities
= Probability for the severity of the 1st loss (refer severity distribution in
Table 3-3) x
Probability for the severity of the 2nd loss (refer severity distribution in
Table 3-3) x
0.01 (probability that loss frequency is 2 in Table 3-2)
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(E)
RM0
RM100,000
0.9
0.1
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Q: What happens to Ricks risk if he agrees to pool his risk with Vic, a
second restaurant owner.
Assumptions:
a. Both parties have homogeneous risk characteristics, i.e. they exhibit
the same level of risk, represented by Ricks liability loss distribution.
b. Each pool members loss experience is statistically independent of
the other members.
c. Each person entering the pool agrees to pay the mean loss of the
pool = All losses incurred by pool members
No. of people in the pool
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RM0
RM50,000 RM100,000
Variance
Standard deviation =
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Ricks expected loss & risk in the pool versus not in the pool:
Expected value
Standard deviation
RM10,000
RM30,000
RM10,000
RM21,213
Risk is
REDUCED
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A further reduction in risk will result from increasing the size of the
pool:
2. Normal Distribution
In Table 3-7: When the number of objects in a risk pool is fairly large
(e.g. over 30), we can assume that the mean loss for that risk pool is
normally distributed.
Normally distributed random variables exhibit several unique
statistical characteristics that are useful in risk pooling:
a. If we plot the values of the mean loss (in RM) on the x-axis &
probability corresponding to the loss amounts on the y-axis, the
resulting graph (normal curve) will be shaped like a bell.
The centre of the normal curve will correspond to the mean /
expected value of the mean losswith probabilities for all other
values of the expected value distributed symmetrically around the
centrebut decreasing in probability as we move further away from
the expected loss.
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b. A statistical relationship exists between the standard deviation & the area under the normal curve.
The range of values found by adding & subtracting 1 standard deviation to the mean of the random
variable accounts for 68.26% of the area under the curve.
The range of values found by adding & subtracting 2 standard deviations to the mean of the random
variable accounts for 95.44% of the area under the curve.
The range of values found by adding & subtracting 3 standard deviations to the mean of the random
variable accounts for 99.74% of the area under the curve.
In
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E.g. Based on Table 3-7, the mean loss distribution for a pool of 36
restaurants is compared to the mean loss distribution for a pool of 100
restaurants (Figure 3-1).
Both risk pools are normally distributed & centered around RM10,000, the
expected loss.
Since 95.44% of the area under the normal curve must fall within a range of 2
standard deviation above & below the mean value
Pool Size
Confidence Interval
Range of Values
36
100
The shape of the normal distribution for the larger pool size is taller & thinner.
There is a much higher probability that the insurers estimated mean loss will
fall very close to the actual expected loss of RM10,000 for the normal curve
associated with a pool size of 100.
By contrast, the corresponding graph for a pool of 36 restaurants is much
shorter & broader.
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Thus, for smaller pool sizes, there is an increased probability that the
estimated mean loss will fall some distance away from the expected
loss of RM10,000.
3. Risk Charges, Confidence Intervals & the Normal Distribution
Confidence = Estimated mean (k) x Estimated standard
Interval
loss
deviation
Risk Charge
k = A specified no. of standard deviations that is added & subtracted to the
estimated mean loss to reflect the uncertainty resulting from forecasting
losses.
We can use confidence intervals to determine the amount of money
that Rick needs to hold in reserve to meet his obligation to the risk pool.
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Since our principal concern is making sure that we have enough funds
to pay for the loss if it turns out to be bigger than its expected value, we
typically focus on the upper tail of the confidence interval (sum of the
estimated mean loss + risk charge)to make sure that we have enough
funds if the loss turns out to be larger than the expected loss amount.
4. Practical Considerations in Using Risk Pooling
When consumers purchase insurance products (e.g. life & auto
insurance), insurers generally use risk pooling to minimise both the risk
& premiums they charge.
These products satisfy the assumptions underlying risk pooling...
a. Insurers can sort consumers into homogeneous risk categories based
on simple risk classification variables. E.g. Age, gender.
b. Independence assumption is generally satisfied because consumers of
these products are not usually plagued by widespread catastrophic
losses in which 1 event can result in a loss that affects a large number of
policyholders in a pool.
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On the other hand, insurance is often not available for risks that violate
the assumptions underlying risk pooling...
a. Insurers cannot use pooling to reduce risk when the number of the
exposures units is small...in part because they have insufficient data
with which to forecast losses.
b. Some types of risks are difficult to insure because the losses are not
independently distributed & can financially ruin an insurer.
E.g. Floods, war & unemployment, which are subject to catastrophic
episodes in which large numbers of policyholders are affected
adversely at the same time.
Insurance companies do not have exclusive rights to risk pooling.
Risk managers have increased their use of this technique dramatically
as an alternative to buying insurance.
E.g. Large employers with thousands of employees often use pooling
to self-insure some of their areas of risk, especially workers
compensation & employer-sponsored health insurance.
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W1 & W2 = Weight / proportion of the pool that consists of the first &
second group members.
SD1 & SD2 = Standard deviation of losses for the first member & the
second member.
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Variance of the risk pool when all losses of all pool members are
independent of each other (VarP):
VarP = (W12 x SD12) + (W22 x SD22)
=
SDP =
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VarP =
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SDP =
X : The standard deviations for the correlated risk pool across all
pool sizes will always be greater than that for the pool of
independent exposure units.
Q: Why would losses be positively correlated in a risk pool?
Positive correlation arises when a common factor / condition causes
a large number of pool members to have a loss.
E.g. Many potentially catastrophic natural disasters (e.g. floods &
earthquakes) are positively correlated because they affect scores of
people & firms simultaneously.
These loss exposures are often excluded from coverage in many
insurance contracts because insurers are not willing to expose
themselves to a financially catastrophic loss event.
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12
6
2
RM5,000
RM10,000
over RM10,000
n = 20
Q: Which coverage bid should she select, based on the number of
expected claims & the magnitude of these claims?
Assumptions:
a. Premiums are paid at the start of the year.
b. Losses & deductibles are paid at the end of the year.
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FV_
(1 + i)n
=
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