Risk and Insurance

Foundation Concepts
• Definition of Risk

– Expected Value

– Variability around the Expected Value

Definitions Definitions

Risk - Unpredictable Outcome Speculative Risk

Loss
Pure Risk No Loss
Loss Gain
No Loss

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 Definitions (Cont.) Definitions (Cont.)

Risk Averse - Prefer to Avoid Risk Exposures

Willing to Pay More than Expected Loss to
Avoid Risk - Person or Property Facing
Pure Risk

Risk Seeker - Prefer Risk

Would Pay More than Expected Return to
Engage in Risky Situation

Definitions (Cont.) Definitions (Cont.)

Personal Loss Exposures Property Loss Exposure
- Damage to Items
- Affect Life, Health or Direct Loss - Cost of
Income of an Individual Repair (Replacement)
Consequential Loss -
Additional Costs

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 Peril
Definitions (Cont.)
• A peril is defined as a cause of loss.
Liability Loss
Exposure
– If your house burns because of fire,
- Responsible for the peril or cause of loss is “fire”.
Damages to Others
– If your car is damaged in a collision
with another vehicle, the peril is
“collision”.

Exposure Analysis: Restaurant

Example of Perils
Example
Natural Human Perils Systematic
Perils Perils
1. Valued Thing Freedom from legal Building
Fire Embezzlement Changes in
liability
Wind Discrimination Consumer
Hail Kidnap Tastes 2. Peril Customer slips and Fire
Earthquake Pollution Depression injures herself
Flood Theft Inflation
Collision Terrorism Obsolesce 3. Financial Cost to defend and Loss in building
Ice Riot Technological Consequence settle claim value
Collapse Vandalism Advances
Loss of income
War

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 Definitions (Cont.) Definitions (Cont.)
Hazards Physical Hazards
- Conditions - Property Conditions
Affecting Perils Intangible Hazards
- Attitudes and Culture

Definitions (Cont.) Probability Distribution

Intangible Hazards -
Moral Hazard - Fraud
Societal Hazards - Legal and Cultural
• Identifies all possible outcomes for a
random variable and the probability of the
outcome
• What is a random variable?
– A variable whose outcome is uncertain.

• How does this relate to the definition of

risk?

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 Key Point Two Types of Distributions
• Sum of the probabilities must equal 1
• Discrete
• Example of flipping a coin
• Continuous
Possible Outcomes Probability
for X
$1 ½ or 0.5 or 50%
-$1 ½ or 0.5 or 50%

Presenting Probability
Distributions Example of a Discrete
• Two ways of presenting probability
Probability Distribution
distributions: – Random variable = damage from auto accidents

– Numerical listing of outcomes and probabilities Possible Outcomes for Damages Probability
$0 0.50
$200 0.30
– Graphically $1,000 0.10
$5,000 0.06
$10,000 0.04

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 Example of a Continuous
Example of a Discrete Distribution
Probability Distribution

Probabilities with Continuous

Continuous Distributions Distributions
• Find the probability that the loss > $5,000
• Important characteristic of continuous • Find the probability that the loss < $2,000
• Find the probability that $2,000 < loss < $5,000
distributions
– Area under the entire curve equals one
Probability

– Area under the curve between two points gives

the probability of outcomes falling within that
given range
Possible
$2,000 $5,000 Losses

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 Summary Measures of Loss
Distributions
• Instead of comparing loss distributions, we often
work with summary measures of distributions:
Frequency
• Frequency measures the number of losses in a
given period over the number of exposures to loss.

– Frequency • If Sharon Steel Corp. had 10,000 employees in

each of the last five years…
– Severity

– Expected loss • And, there were 1,500 injuries over the 5-year
period…
– Standard deviation or variance

– Maximum probable loss (Value at Risk) • Then, the loss frequency would be 0.03 =
1500/50,000 employee-years.
• How does RM affect each of these measures?

Expected Loss
Severity • The Expected Loss is simply the product of
the frequency and the severity
• Severity measures the magnitude of loss per
occurrence.
• Expected loss = Frequency x Severity
• If the 1,500 injuries cost a total of
$3,000,000… • In our example, the Expected Loss equals
$60
• Then, the expected severity of loss would ¾0.03 x $2,000 = $60
be $2,000. ¾Also known as the “pure premium”

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 Expected Value Expected Value
• Formula for a discrete distribution:
– Expected Value = μ= x1 p1 + x2 p2 + … + xM pM .
– Example:

Possible Outcomes for Damages Probability

$0 0.50
$200 0.30
$1,000 0.10
$5,000 0.06
$10,000 0.04

Expected Value = $0 + $60 +$100 + $300 + $400 = $860

Standard Deviation and Variance Variance and Standard Deviation

– Standard deviation indicates the expected magnitude of N
the error from using the expected value as a predictor of
the outcome
• Variance = Σpi(xi - μ)2
i=1

– Variance = (standard deviation) 2

– Standard deviation (variance) is higher when • Standard Deviation = Square Root of the
• when the outcomes have a greater deviation from the expected
value
Variance
• probabilities of the extreme outcomes increase

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 Standard Deviation Calculation
Standard Deviation and Variance
for Distribution 1
– Comparing standard deviation for three discrete 1. Calculate difference between each outcome and
distributions expected value
9 $250-500=-$250
Distribution 1 Distribution 2 Distribution 3 9 $500-500= $0
9 $750-500 =$250
Outcome Prob Outcome Prob Outcome Prob
$250 0.33 $0 0.33 $0 0.4
$500 0.34 $500 0.34 $500 0.2 2. Square the results
$750 0.33 $1000 0.33 $1000 0.4 9 $62,500
9 $0
9 $62,500

Standard Deviation Calculation Standard Deviation Calculation

(cont.) for Distribution 2
3. Multiply by results of step 2 by the respective 1. Calculate difference between each outcome and
probabilities expected value
9 (0.33)($62,500) = $20,833 9 $0-500=-$500
9 (0.34)($0) = $0 9 $500-500= $0
9 (0.33)($62500) = $20,833 9 $100-500 =$500

4. Sum the results 2. Square the results

9 20,833 + 0 + 20,833= $41,666 9 $250,000
9 This is the Variance 9 $0
9 $250,000
5. Take the Square Root = $204.12

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 Standard Deviation Calculation
Standard Deviation and Variance
(cont.)
3. Multiply by results of step 2 by the respective
probabilities
9 (0.33)($250,000) = $82,500
9 (0.34)($0) = $0
9 (0.33)($250,000) = $82,500

4. Sum the results

9 $82,500 + 0 + $82,500 = $165,000
9 This is the Variance

5. Take the Square Root = $406.20

Sample Mean and Standard

Deviation
– Sample mean and standard deviation can and
usually will differ from population expected value
and standard deviation
Maximum Probable Loss
– Maximum Probable Loss at the 95% level is the number,
MPL, that satisfies the equation:
• Probability (Loss < MPL) < 0.95

– Coin flipping example – Losses will be less than MPL 95 percent of the time

$1 if heads
X=
-$1 if tails

• Expected average gain from game = $0

• Actual average gain from playing the game 5 times =

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 Correlation Correlation Examples
– Correlation identifies the relationship between • What is the likely
two probability distributions correlation?
– Example 1:
– Uncorrelated (Independent)
¾Random variable 1:
Auto accidents of an
– Positively Correlated CSU student in 2007
¾Random variable 2:
– Negatively Correlated Auto accidents of
student in Australia in
2007

Correlation Examples Correlation Examples (cont.)

• What is the likely – Example 3:
correlation? ¾Property damage due
– Example 2: to hurricanes in
¾Property damage Miami in Sept. 2008
due to hurricanes in
Miami in Aug & ¾Property damage due
Sept, 2008 to hurricanes in
¾Property damage Miami in Sept. 2005
due to hurricanes in
Ft. Lauderdale in
Aug & Sept, 2008

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Correlation Examples (cont.)
– Example 4:
¾Number of people who die from
AIDS in New York in 2008
¾Number of people who die from
AIDS in London in 2008
Question 1: Buckeye Brewery-
Property Losses
• L = Expected property losses
• L has the following property loss distribution
9 $3,000,000 with probability of 0.004
9 $1,500,000 with probability of 0.010
9 $800,000 with probability of 0.026
9 $0 with probability of 0.96
• What is the expected loss?
Calculating the Frequency and
Severity of Loss
– Example:
• 10,000 employees in each of the past five years
• 1,500 injuries over the five-year period
• $3 million in total injury costs
• Frequency of injury per year = 1,500 / 50,000 = 0.03
• Average severity of injury = $3 m/ 1,500 = $2,000
• Annual expected loss per employee = 0.03 x $2,000 = $60
Question 2: Buckeye Brewery-
Liability Losses
• L = Expected liability losses
• L has the following liability loss distribution
9 $5,000,000 with probability of 0.004
9 $1,500,000 with probability of 0.025
9 $500,000 with probability of 0.03
9 $0 with probability of 0.941
• What is the expected loss?
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 Question 3 – Buckeye Brewery Law of Large Number
• Are Buckeye Brewery’s property losses: • As a sample of
– Independent observations is
– Positively correlated increased in size,
– Negatively correlated the relative
variation about the
mean declines.
• With its liability losses?

Expt Number of
successes
Expt Number of
successes
Expt Number of
successes
Expt Number of
successes
Expt Number of
successes
Tossing a Coin -- An experiment of 100 trials
1 0 21 8 41 14 61 23 81 29
2 0 22 8 42 14 62 23 82 29
3 1 23 8 43 14 63 23 83 30 pn
4 1 24 8 44 14 64 24 84 30
5 2 25 8 45 15 65 25 85 30
6 2 26 8 46 16 66 25 86 31
7 3 27 9 47 17 67 25 87 31
8 4 28 10 48 17 68 25 88 32
9 5 29 10 49 17 69 26 89 32
10 5 30 10 50 18 70 26 90 32
11 5 31 10 51 19 71 26 91 33 0.3437182
12 5 32 10 52 20 72 26 92 33
13 5 33 10 53 20 73 26 93 33
14 5 34 10 54 21 74 26 94 34
15 6 35 11 55 21 75 27 95 34
16 6 36 12 56 22 76 27 96 34
17 6 37 12 57 22 77 28 97 34
18 7 38 13 58 22 78 29 98 34
19 7 39 14 59 22 79 29 99 34 n
20 8 40 14 60 22 80 29 100 35

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 Methods of Handling Pure Risk
• Avoidance
Methods of Handling Pure Risk
• Retention
Methods of Handling Pure Risk
• Loss Control
– Loss Prevention
Reduce Loss Frequency
– Loss Reduction
Lower Loss Severity
Methods of Handling Pure Risk
• Transfer
– Corporations
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Sole Proprietorships
Methods of Handling Pure Risk
• Transfer
– Contractual Agreements
Corporate Structure
Unlimited Liability
Personal tax on profits
Partnerships
Limited Liability
Corporations Corporate tax on profits +
Personal tax on dividends
Definition of Insurance
(Page 52 of text)
Insurance is a social device in which a
group of individuals (insureds)
transfer risk to another party (insurer)
in order to combine loss experience,
which permits statistical prediction of
losses and provides for payment of
losses from funds contributed
(premiums) by all members who
transferred risk.
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 Insurance Versus Gambling
Gambling Creates Risk
Insurance Transfers Existing Risk
Gambling is Speculative Risk
Insurance Deals with Pure Risk
Which, if any, requisites are
violated by the following?
• Mental Health Insurance
• Flood Insurance
• Satellite Launch Insurance
• Tornado Insurance
• Inflation Insurance
• Divorce Insurance
• Mutual Fund Insurance
Ideal Requisites for Insurability
1 Large Number of Similar Exposure Units
2 Fortuitous Losses
3 Catastrophe Unlikely
4 Definite Losses
5 Determinable Probability Distribution
6 Economic Feasibility
Types of Insurance
• Personal or Commercial
• Life-Health or Property-Liability
• Private or Government
• Voluntary or Involuntary
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 Types of Insurance - Examples
Social Security Medical Malpractice
• Personal • Commercial
• Life-Health • Property-Liability
• Government • Private
• Involuntary • Voluntary

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