CIC 3019 INSURANCE AND RISK MANAGEMENT (SEM2, 2019/2020)

Chapter 3: Quantifying Risks

Tutorial questions
1. What information is given by a probability distribution? What are the two ways of illustrating
a probability distribution?

A possibility distribution identifies all the possible outcomes and the probabilities of those
outcomes for a particular random variable. Simple probability distributions can be described
by listing the possible outcomes and the corresponding probabilities. Probability distributions
can be described graphically, with the possible outcomes listed on the horizontal axis and the
probabilities of these outcomes measured on the vertical axis.

2. Skewness measures what characteristic of a loss distribution? Why are skewed distributions
relevant to risk managers?
Skewness measures the symmetry of a loss distribution (or, the lack of it). If a distribution is
symmetric, it has no skewness. Skewed distributions are relevant to risk managers because it
will give an indication of the probability of large losses and its (most likely) low probabilities
of occuring. In other words, understanding skewness allows risk managers to understand the
severity of the loss (the amount of loss) and the frequency loss (the probability of the loss).
Compared to normal or symmetry distributions, skewed distributions will have higher
probability of very low losses (region A) but also a higher probability of higher losses (region
B), while normal distributions will have a symmetrical distribution with no extreme high
probabilities nor amount of losses.

Region A

Skewed
distribution
Probability density

Normal
distribution

Region B

Amount of losses (in $ ‘000)

3. Among the following types of risk, which would you expect to have the most skewed
probability distribution and which are more normally distributed? (Assume a time period of
one year.)
a. shoplifting losses for a small bookstore
b. collision damage to vehicles for a delivery service
c. product liability claims for a drug manufacturer
d. employee injuries in a grocery store

Among the types of risk listed above, product liability claims for a drug manufacturer (c) would
have the most skewed probability distribution because the probability of having very huge amount
of loss will most likely be very small (remember the right skew in Question 2). The other types of
risk are more likely to be normally distributed as the loss would be small with very small possibility
of a large loss. Small bookstores will likely to have some shoplifting cases (probably among
youngsters) but the losses are not huge as compared to all books burning down in a fire. Collision
damage to vehicles for a delivery service may also occur with moderate losses since it is in the
delivery business where vehicle movement is the norm, but large losses will be quite possible
(although not as large as the liability claim of a drug manufacturer). Employee injuries in a
grocery store may also be likely and normally distributed throughout the year. The injuries can be
assumed to be quite minor, and may not happen that frequently. In summary, C will be the most
skewed distribution and A will be the most normally distributed. B and D will be somewhere in
between.

4. Earthquakes are rare in Malaysia, but the property damage can be very large when they occur.
Illustrate these features by drawing a probability distribution for property losses due to an
earthquake for a business that has property valued at RM50million. Identify on your graph the
probability that losses will exceed RM30 million.
The following probability distribution indicates that the probability of loss losses is relatively
high, but that the probability of very high losses is relatively low. The maximum loss (ignoring
indirect losses) is RM50million. The shaded area is the probability that losses exceed
RM30million.
Probability density

RM30 RM50

Amount of losses (in millions)

5. a. Assume that property losses for JJ Company have the following distribution:
Possible loss Probability
RM3,000,000 0.004
RM1,500,000 0.010
RM800,000 0.026
RM0 0.96
What is the expected value of property loss?
Possible loss (RM) Probability Exp. Loss (RM)
3000000 0.004 12000
1500000 0.01 15000
800000 0.026 20800
0 0.96 0
47,800

b. Assume that JJ Company has the following probability distribution for liability loss:
Possible loss Probability
RM5,000,000 0.004
RM1,500,000 0.025
RM500,000 0.030
RM0 0.941
What is the expected value of liability loss for JJ Company?
Possible loss
Probability
(RM) Exp. Loss (RM)
5,000,000 0.004 20,000
1,500,000 0.025 37,500
500,000 0.030 15,000
0 0.941 0
72,500

c. Do you think that JJ Company’s property losses are independent, positively correlated, or
negatively correlated with its liability? Explain.
The property losses positively correlated because when property is damaged (e.g.
perhaps in a fire), there is a greater chance that people will be injured and lawsuits will
be filed.
6. Over the last eight years, a construction company, Bina Builders Company has averaged
10,000 employees per year, 641 worker injuries (on the job) at an annual average cost of
RM134,369. Using this data
a. Compute the probability of a worker suffering an on-the-job injury
b. Compute the average injury severity
c. Compute the expected loss per worker

Answer:
 641 
a.    6.41%
 10,000 

 $134,369 
b.    $209.62  in this case annual average cost of $134,369 is the total cost
 641 
for all injuries of the affected workers in the company. So here we are computing the
average injury severity per injured worker.

c. Exp. Loss per worker = (.0641)($209.62)=$13.44  here we are computing the

expected loss per worker for the total number of workers at Bina Builder Company.

7. Assume that two business owners each own an identical storage building valued at RM50,000
and that there is a 10 percent change in any year that each building will be destroyed by a fire,
and that a loss to either building is an independent event.
a. Compute the expected loss resulting from fire for each owner (hint: there are two
possible outcomes: loss or no loss).
b. Compute the variance and standard deviation for each owner (separately).
c. Assume that the two owners decide to pool their loss exposures, and each agrees to pay
an equal share of any loss that might occur. Under this scenario, compute the expected
loss arising from a risk pooling agreement. (hint: there are now four possible
outcomes). Also compute the variance and standard deviation for this risk pooling
arrangement.
d. What can you observe from the risk pooling agreement?

Answer:
a. Expected loss resulting from fire for each owner.

Possible
Possible Probability Exp. Loss Variance = ∑
outcome xi-µ (xi-µ)2
outcome pi ∑xi*pi pi(xi-µ)2
(RM)
No loss 0 1 0 -5,000 25,000,000 22,500,000
Loss 50,000 0 5,000 45,000 2,025,000,000 202,500,000
µ=5,000 225,000,000
b. Variance 225,000,000
Std Dev. 15,000
c.

Loss borne by
Possible Pooled
Possible each person Exp. Loss Variance =
outcome Probability xi-µ (xi-µ)2
outcome (RM) ∑xi*pi ∑ pi(xi-µ)2
(RM) pi
xi
A&B No loss 0 0 0.9 0 -5000 25,000,000 22,500,000
A Loss, B no
50,000 25,000 0.09
loss 2,250 20,000 400,000,000 36,000,000
B Loss, A no
50,000 25,000 0.09
loss 2,250 20,000 400,000,000 36,000,000

A & B loss 100,000 50,000 0.01 500 45,000 2,025,000,000 20,250,000

µ = 5,000 114,750,000
Variance 114,750,000
Std Dev. 10,712

d. We can observe the following from the risk pooling arrangement:

i. The probability of the largest loss occurring is reduced from 0.1 to 0.01 because the
chances of them paying RM50,000 will only occur when BOTH of them are involved in
accidents. The probability is lower because it is assumed that the losses are uncorrelated
– the occurrence of a loss is independent of each other.
ii. The probabilities of extreme outcomes are lower. This is reflected in the lower standard
deviation (15,000 compared to 10,712)
iii. The standard deviation has become smaller, this means that the risk is smaller and can be
predicted with more certainty.

8. Identify for each of the items below, whether the specific variables, or exposures, for the
identified group(s) or context are most likely positively correlated, negatively correlated, or
uncorrelated.
Variables or Exposure Correlation
Unemployment amongst the employees of an airline company Positive
The number of auto accidents, in a given year, for each resident in
Uncorrelated
Klang Valley
Total damage from house fires in Johor Bahru and total damage from
Uncorrelated
house fires in Perlis
Number of days with rainfall and volume of paying customers at a
Negative
public outdoor swimming pool.
Flood damages to homes in Kota Bahru, Kelantan. Positive