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CHAPTER 2

RISK ASSESSMENT, POOLING


& DIVERSIFICATION

(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)

BASIC STATISTICAL CONCEPTS

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

When we do not know the probability of a random variable in


advance, we must estimate it, often from prior experience / industry
data.

E.g. Rick, the owner of Ricks Restaurant. Based on conversations


with attorneys, risk consultants & other restaurant owners, Rick
estimates that he has a 10% chance of losing a RM100,000 lawsuit in
the next year, compared to a 90% chance that he will not be sued.
Ricks loss distribution is shown below:
Loss outcome

RM0

RM100,000

Probability of loss outcome

All probability distributions share some important characteristics:


1. The maximum probability for any 1 outcome of a random variable will
always be less than 1.0 & the minimum probability for any 1 outcome
is always greater than zero.
2. The probability distribution also must include all possible values of
the random variable with probabilities greater than zero...regardless
of how small their chance of occurrence may be.
We can be sure that we have accounted for all values of such
random variables if the sum of their probabilities equals 1.0.
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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.

4. Variance & Standard Deviation

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)

RISK ASSESSMENT: ESTIMATING LOSS


FREQUENCY & LOSS SEVERITY

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.

Average = Total dollar amount of losses


Loss
Total no. of cars
= Total amount of losses x Total no. of accidents
Total no. of accidents
Total no. of cars
= Average loss severity x Average loss frequency
Average size of loss

Frequency with which


losses occur

Suppose that Rebecca has gathered the information shown in


Columns 1 3 of Table 3-2 about the number of losses incurred
by her fleet of 1,000 cars in the past year.
2 ways to find the average loss frequency:
1. Average loss frequency per car = Total no. of losses
Total no. of cars

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2. Average frequency
= No. of losses per car x Estimated probability

2 ways to find the average loss severity:


1. Average severity per accident = Total amount of losses
Total no. of losses
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2. Average severity
= Amount of loss x Estimated probability

2 ways to find the average loss per car:


1. Average loss per car = Total dollar amount of losses
Total no. of cars

2. Average loss per car = Average severity x Average frequency

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(D)

CONVOLUTION

Calculates all possible combinations of losses indicated by the


frequency & severity loss distributions & their corresponding
probabilities of occurring.
Often done by computer simulation due to complexity of calculations.

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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)

DIVERSIFICATION OF RISK USING RISK


POOLING

Exposure units: Persons / objects exposed to risk.


The more exposure units in a pool, the more accurately the insurer
can predict any individual units risk of loss.
Risk pooling: The ability to reduce each exposure units risk by
making more accurate predictions about a large pool of units.
1. Change in Risk Through Pooling
E.g. Rick estimates that he has a 10% chance of losing a RM100,000
lawsuit in the next year, compared to a 90% chance that he will not be
sued. Ricks loss distribution is shown below:
Loss outcome

RM0

RM100,000

Probability of loss outcome

0.9

0.1

Expected value = RM10,000

Standard deviation = RM30,000

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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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New mean loss distribution for the pool:


Mean loss outcome

RM0

RM50,000 RM100,000

Probability of mean loss outcome

Expected value of mean loss


=

Variance

Standard deviation =

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Ricks expected loss & risk in the pool versus not in the pool:
Expected value

Standard deviation

Unpooled loss distribution

RM10,000

RM30,000

Pooled loss distribution

RM10,000

RM21,213

Mean loss remains


the same

Risk is
REDUCED

Most importantly, the probability of the largest loss amount


(RM100,000) has decreased dramatically from 10% to 1%...
Because it is extremely unlikely that Rick & Vic will both lose a lawsuit
in the same year.

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A further reduction in risk will result from increasing the size of the
pool:

Standard deviation of = Unpooled standard deviation


mean loss distribution
No. of pool members

Standard deviation decreases with an increased number of pool


members.
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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

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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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(F) RISK DIVERSIFICATION


Risk-bearing group: The group that is formed as part of the risk
diversification process.
E.g. Insurance policy owners are grouped into risk pools.
Expected value of the group is a weighted average of the expected
values of each group member.
E.g. For a group consisting of 2 members, the expected value (EVG)
for the group:

EVG = (W1 x EV1) + (W2 x EV2)


W1 & W2 = Weight / proportion of the group that consists of the first &
second group members.
EV1 & EV2 = The expected value for the first & second members.

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Variance for a risk group (VarG) with 2 random variables is a


weighted sum of the variances of the random variables plus a
weighted value for the correlation between them.
VarG = (W12 x SD12) + (W22 x SD22) + (2 x W1 x W2 x SD1 x SD2 x Corr12)

W1 & W2 = Weighting variables that reflect the proportion of the portfolio


that consists of random variables 1 & 2, respectively.
SD1 & SD2 = Standard deviation for random variables 1 & 2,respectively.
Corr12 = Correlation between random variables 1 & 2.

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1. Risk Diversification in Uncorrelated Groups: Insurance Risk


In insurance risk pooling, an underlying assumption used was that
the potential losses of all the exposure units in the pool were
independently distributed.
This means the correlation among them equals zero.
Variance of the insurance pool:
VarP = (W12 x SD12) + (W22 x SD22)

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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2. Risk Pool with 2 Exposure Units


E.g. Rick & Vic, the 2 restaurant owners who agreed to share their
exposure to liability risk jointly in a 2-person risk pool.
Each restaurant owner faced a mean loss equal to RM10,000 with a
standard deviation of RM30,000.
Expected value resulting from this risk pool (EVP):
EVP = (W1 x EV1) + (W2 x EV2)
=

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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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3. Risk Pool with More Than 2 Exposure Units


For a larger risk pool consisting of n independent exposure units:
EVP = (W1 x EV1) + (W2 x EV2) + ... + (Wn x EVn)
VarP = (W12 x SD12) + (W22 x SD22) + + (Wn2 x SDn2)
E.g. If Vic & Rick were able to attract into their pool 2 additional
restaurant owners with homogeneous liability exposures
independent of their own => 4-firm risk pool:
EVP =

VarP =

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Combining independent & uncorrelated exposure units in a risk pool


results in a significant reduction in risk with relatively modest pool
sizes
Because the standard deviation of the risk pool varies inversely with
the square root of the number of independent exposure units in the
pool.

Table 5-4: With large pool sizes, standard deviations decrease to


levels approaching zero.
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4. Correlated Loss Exposures & Insurance Complications


If the losses from an insurance risk pool are positively / negatively
correlated:
VarP = (W12 x SD12) + (W22 x SD22) + (2 x W1 x W2 x SD1 x SD2 x Corr12)

In particular, positively correlated exposure units pose a difficult


challenge for insurersbecause they limit the ability to decrease risk
through diversification.
Table 5-4 demonstrates how the existence of positive correlation
among exposure units can hamper risk diversification.
For Correlation = 0.1: Each pool member is assumed to be
homogeneous with Rickbut whose losses are positively correlated
at a 0.1 level.
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E.g. Size of Pool = 2


VarP = (W12 x SD12) + (W22 x SD22) + (2 x W1 x W2 x SD1 x SD2 x Corr12)
=

SDP =

Comparing these measures of risk to the top row (i.e. measures of


risk associated with uncorrelated loss exposures) reveals a good
news bad news scenario.
: Insurers can reduce the risk of losses in positively correlated risk
pools by increasing the number of exposure units in the pool.
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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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(G) FINANCIAL ANALYSIS IN RISK


MANAGEMENT DECISION MAKING
2 applications of the concept of time value of money in risk
management decision making:
1. Analysing Insurance Coverage Bids
E.g. A risk manager would like to purchase property insurance on
a building. She is analysing 2 insurance coverage bids. The bids
are from comparable insurance companies & the coverage
amounts are the same. The premiums & deductibles, however,
differ.
Insurer As coverage requires an annual premium of RM90,000
with a RM5,000 per-claim deductible.
Insurer Bs coverage requires an annual premium of RM35,000
with a RM10,000 per-claim deductible.
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The risk manager wonders whether the additional RM55,000 in


premiums is warranted to obtain the lower deductible.
Using some loss forecasting methods, the risk manager predicts the
following losses will occur:
Expected No. of Losses

Expected Size of Losses

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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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c. 5% is the appropriate interest (discount) rate.


With Insurer As bid, the expected cash outflows in 1 year would be
the 1st RM5,000 of 20 losses that are each RM5,000 / >, for a total of
RM100,000 in deductibles.
Present value of deductibles:
PV =

FV_
(1 + i)n
=

PV of total expected payments


= Insurance premium at the start of the year + PV of deductibles
=
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With Insurer Bs bid, the expected cash outflows for deductibles at


the end of the year:

Present value of deductibles:


PV =

PV of total expected payments


= Insurance premium at the start of the year + PV of deductibles
=

Decision: Because the PVs calculated represent the PVs of cash


outflows, the risk managers should select the bid from Insurer B
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because it minimises the PV of the cash outflows.

2. Loss-Control Investment Decisions


Loss-control investments are undertaken in an effort to reduce the
frequency & severity of losses.
Such investments can be analysed from a capital budgeting
perspective by employing time value of money analysis.
Capital budgeting: A method of determining which capital
investment projects a company should undertake.
Only those projects that benefit the organisation financially should
be accepted.
If not enough capital is available to undertake all of the acceptable
projects, then capital budgeting can assist the risk manger in
determining the optimal set of projects to consider.
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A number of capital budgeting techniques are available:


a. Net present value (NPV): The sum of the PVs of the future net
cash flows minus the cost of the project.
b. Internal rate of return (IRR): The average annual rate of return
provided by investing in the project.
E.g. The risk manager of an oil company that owns service stations
may notice a disturbing trend in premises-related liability claims.
Patrons may claim to have been injured on the premises (e.g. slipand-fall injuries near gas pumps / inside the service station) & sue
the oil company for their injuries. The risk manager decides to
install camera surveillance systems at several of the problem
service stations at a cost of RM85,000 per system. The risk
manager expects each surveillance system to generate an aftertax net cash flow of RM40,000 per year for 3 years.
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PV of future cash flows (assume interest rate = 8%)


=

NPV = PV of future cash flows Cost of project


=

As the project has a positive NPV, the investment is acceptable.


Alternatively, the projects IRR could be determined & compared to
the companys required rate of return on investment.
IRR is the interest rate that makes the NPV = 0.
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RM40,000 + RM40,000 + RM40,000 = 0


(1 + IRR)1
(1 + IRR)2
(1 + IRR)3
IRR =

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