CHAPTER 3

RISK MEASUREMENT
 Overview

• Characteristics of risk data

• Data collection method
• The measurement of risk
• Presentation of risk data
INTRODUCTION
• Measurement is the process of evaluating the importance
of an exposure to risk to an organization

• Risk measurement is fundamental to the insurance

industry, from the pricing of individual contracts to the
management of insurance and reinsurance companies to
the overall regulation of the industry.

• It provides fundamental support to decision making

within the insurance industry
Risk data
❖Purposes of having risk data;
▫ Insurance relies on accurate figures/data
➢Data have to be collected, tabulated, described
and measured. Estimates of likehood, premiums
calculated, losses paid, reinsurances arranged.

▫ The quantitative of world of business

➢Aided by the advent of the computer – it is no
longer sufficient simple to be literate – must also
numerate
▫ A disciplined pattern of thought
➢Result can be a more logical pattern of thought
and orderly approach to problem solving
Characteristics of risk data
• 2 special features of risk data: frequency with which
events occur, severity of each event

• There are two main reasons to measure potential

severity:

1. To classify the risks into critical, important, or

unimportant exposures. The potential losses should be
ordered in importance according to their loss severity

2. To determine the amount of insurance to buy. Over

insuring will result in unnecessary costs, while
inadequate cover may mean unbearable costs.
MEASURING FREQUENCY &
SEVERITY

• The loss frequency gives the distribution of the number

of losses per year from a given exposure.

• The severity distribution is the distribution of the dollar

amount lost when a loss occurs.

• The goal of risk management is to combine these two

distributions to derive the distribution of total annual
losses. This depends on both the number of losses that
occur and the severity of individual losses.
Risk pattern

➢ High frequency – low

severity losses

➢ Low frequency – high

severity incidents
Risk profile

Left- • High number , low cost

• Predictable
hand • Little potential for catastrophe

• Medium number, medium severity

Middle • Not easy to predict
• Aggregate cost could be serious

Right- • Low number, very high cost

• Extremely difficult to predict
hand • Catastrophe potential
 Risk profile

• Building up this picture of the risk can now help

the firm decide on its strategy for funding the
risk
 Data Bases

• Database is simply a way of describing the raw materials

of numerical calculations

• In insurance business, it depends largely with statistics

and the database represents the raw data statistics.
 Data Bases
• Raw data/data base can be used to produce some kind of
end result:

 Used to describe what has happened in the past. For

example, data on motor accidents is used to describe a
number of different features (the difference in cost of
between makes of vehicles, any relationship between
the age of driver and cost and etc)

 Used as the basis for some forecast, decision and

judgment. It can be gathered on a particular type of
risk and on the basis of that data, it may be possible to
arrive at a suitable premium rate.
 Direct
observation

Interview

Primary

Experiments

Questionnaires
Methods of Collecting
Data

Published data

Secondary Government

Data Bases
1. DIRECT OBSERVATION

 Most accurate methods of collecting data with limited

ambiguity and not to rely on the interpretation of others

 In insurance, it is quite difficult to see an application of

direct observation but it can sometimes be carried out in
the area of loss control.

 For example, a risk manager could observe the number of

times that goods were stacked on shelves too close to
sprinkler heads.

 However, the cost of collecting data in this way is quite

expensive.
2.INTERVIEWS

 This will be appropriate where the insurers engaged in

any form of attitude study such as the attitude of
insured towards the service they obtain from branch
offices.

 The possibility of error exists anyway.

 For example the respondent might wrongly interpreted

the question, interviewer wrongly interpreted the
answer given and all sorts of ambiguity.
3.EXPERIMENTS

 Many insurer plays an active part in developing new

loss control mechanism over a range of risk.

 A set of new experiments could be designed and

carried out and the resultant data would then
become the raw material upon which the analysis of
the efficacy of the technique would be carried out.
4. QUESTIONNAIRES

 The most common methods for generating raw data.

 A form is designed and sent to people for their completion

 The person completes the form and returns it.

 Assuming that the correct questions had been asked in the

first place, the raw data generated from the completed
forms can then be analyzed.

 Advantages : speed and cost savings.

 Disadvantages : the poor response rate, low percentage of

questionnaires are returned and often with incomplete and
wrongly completed forms.
PUBLISHED DATA
1) THE GOVERNMENT

 The government of Malaysia, like many others

government around the world, collect a range of
statistics which they consider necessary for different
purposes.

 Basic information on population, government

income and expenditure, defense, production,
inflation etc. is all collected and available to the
general public.
2. EXISTING DATA BASES

✓ Generated within the insurance industry

✓ In the form of policy information, claims data,
sum insured, investments, staff numbers, and
assets etc.
✓ Insurance business relies on the free flow of
information for its smooth operation
✓ Its also generates a substantial amount of
information.
POPULATIONS AND SAMPLES
• POPULATIONS

 The full set or numbers of objects, people or

circumstances which is to be the subject of the study.

 For example, populations of motor claims, fires,

branch offices, injured people, houses and etc.
• SAMPLES

 From a smaller subsection of this entire set.

 In insurance, there might have a very large numbers

of incidents such as claims.

 These large numbers of incidents are only a subset of

a larger populations.

The motor claims which the insurer experiences is

only a subset of the whole populations of motor
claims but since it may be a large enough number to
be looked upon as a population and many insurers
would use it in this way.
Tables Bar Chart Pie Chart
➢Frequency distribution
➢Relative frequency
➢Cumulative frequency
➢Histogram
Tabulation of the values that one or more
variables take in a sample

Claim cost (RM) Number of Claims

0< 500 10
500<1000 15
1000<1500 25
1500< 2000 30
2000< 2500 20
Frequency is expressed as percentage of the total
frequency

Number of Relative
Claim cost( RM)
Claims Frequency
0< 500 10 10%
500<1000 15 15%
1000<1500 25 25%
1500< 2000 30 30%
2000< 2500 20 20%
Total 100 100%
To determine the number observations that lie above (or
below) a particular value in a data set.

Claim cost( Number of Relative Cumulative frequency

RM) Claims Frequency Less than More than

0< 500 10 10% 10% 100%

500<1000 15 15% 25% 90%

1000<1500 25 25% 50% 75%

1500< 2000 30 30% 80% 50%

2000< 2500 20 20% 100% 20%

Total 100 100%

An exact drawing or representation of the data
from frequency distribution table.
 Number of Relative
Cost (RM) P(x)
shops Frequency (%)

0 < 200 90 45 0.45

200 < 400 70 35 0.35

400 < 600 20 10 0.10

600 < 800 15 7.5 0.075

800 < 1 000 5 2.5 0.025

Total 200 100 1.000

.

Use the midpoint of the class or range and we are

going to use the same formula;

Cost Mid Point (x) P (x) P (x). x

RM 315 is the
0 < 300 150 0.6 90 expected cost
per theft and
300 < 600 450 0.3 135 the total cost
in a year.
600 < 900 750 0.06 45

900 < 1 200 1 050 0.03 31.5

Total 1.00 315

❖Average of the data distribution.
❖Risk manager can used arithmetic mean by
using historical data.
❖Simple arithmetic data

x=∑

❖Frequency Distribution Data

❖Grouped Data
❖A high variance denotes the actual outcome is
close to expected value.
❖In order to calculate the standard deviation, one
must calculate the variance first.
▫ Variance :

▫ Standard Deviation :
 Midpoints
Cost Frequency f
(x)
0 < 300 270 150 40500 22500 6075000

300 < 600 135 450 60750 202500 2733750

600 < 900 27 750 20250 562500 15187500

900 < 1 200 14 1 050 14700 1102500 15435000

1 200 < 1
4 1 350 5400 1822500 7290000
500
Total 450 141600 3712500 46721250

= 69.35
The end……………….