BBMF2083 INSURANCE MANAGEMENT

CHAPTER 2 RISK ASSESSMENT & EVALUATION (ANSWERS)

Risk Assessment & Evaluation Questions:

1. Scary Airline predicts that the annual probability of 1 of its jets being destroyed in a crash is 1 in
10 million. If destroyed, the value of the property damage to the plane equals RM50 million.
Assume that there are no partial losses; the plane is either destroyed in a crash or suffers no loss. a)
Show the physical damage loss distribution for Scary Airline’s planes.

Physical damage loss distribution for Scary Airline’s Planes

No crash crash

Loss Outcomes RM0 RM50,000,000

Probability of loss outcome 10mil-1/10 mil = 0.9999999 1/10mil = 0.0000001

Con: Therefore, the probability of loss outcome of RM0 is 0.9999999 and the probability of loss
outcome of RM50,000,000 is 0.0000001.

b) Calculate the expected value of the physical damage loss.

F: Expected loss = Σ Ri * Pi
W = (RM50,000,000 x 0.0000001) + (RM0 x 0.9999999)
= RM5
C: Therefore, the expected value of physical damage loss is RM5.
 c) Show the calculations for the variance and standard deviation.

Loss Outcomes Probability Loss Outcome - (Loss Outcome - (Loss Outcome -

Expected Loss Expected Loss)^2 Expected Loss)^2 x
Probability

RM 0 0.9999999 RM0 - RM5 = - RM(-5)^2 = RM25 RM24.9999975

RM5

RM50,000,000 0.0000001 RM50,000,000 RM(49,999,995)^2 RM249,999,950

- RM5 = =RM2,499,999,500
RM49,999,995 ,000,000

1 Variance : RM24.9999975 +
RM249,999,950 =
RM249,999,975

Standard deviation = √Variance

= √RM249,999,975 = RM15,811.3875

In conclusion, the standard deviation for Scary Airlines is RM15,811.3875.

2. Sue is analysing the workers’ compensation (WC) losses of the employees in her firm that occurred
over a 1-year period, based on the following data.
No. of WC Claims No. of Workers Total No. of Claims
Filed / Worker

0 850 0
1 100 100
2 50 100

a) Use the information in the above table to find the average frequency of losses per
worker.
No. of WC No. of Workers Total No. of Claims
Claims Filed /
Worker

0 850 0
1 100 100
2 50 100

1000 200

Average loss frequency per worker = Total no. of losses / Total no. of workers
= 200/1000
 = 0.2 claims per worker
Con: therefore, the Average loss frequency is 0.2 claims per worker

b) Use the information in the table to estimate a probability distribution for the frequency distribute on of
losses per worker in a year.

No. of claims 0 1 2

Probability 850/1000=0.85 100/1000=0.1 50/1000=0.05

The estimation is as above table, the probability of 0 claim is 0.85, ……

Range of Loss Amount Midpoint No. of Losses Total RM

Ringgit Amount of
Amount of Losses
Loss

RM1 – 2,000 RM1,000 180 RM180,000

RM2,001 – 10,000 RM6,000 20 RM120,000
Greater than RM10,000 N/A 0 0

Total 200 300,000

c) Use the information in the above table to find average severity per claim.

Average severity per claim = Total loss paid/ Total No. of claim
=RM300,000 / 200 claims
=RM 1,500 per claim

d) Use the information in the table to estimate a probability distribution for the loss
severity per claim.

Midpoint of RM1000 RM6000

claim range

Probability 180/200=0.9 20/200=0.1

Therefore, the probability of losing RM1000 per claim is 0.9 while the probability of losing RM6000 per
claim is 0.1

e) Using your answers from parts (b) and (d), use convolution to find the average loss.
 Row 1st loss 2nd loss Total Loss Joint Probability Total loss x
Probability Probability

1 - - 0 0.85 0.85 0

2 1000 - 1000 0.1*0.9 0.09 90

3 6000 - 6000 0.1*0.1 0.01 60

4 1000 1000 2000 0.05*0.9*0.9 0.0405 81

5 1000 6000 7000 0.05*0.9*0.1 0.0045 31.5

6 6000 1000 7000 0.05*0.1*09 0.0045 31.5

7 6000 6000 12000 0.05*0.1*0.1 0.0005 6

Total 1.0 300

3. Ahmad’s Toy Store faces the follow probability distribution of fire losses in its store over the next
year:
Probability 0.85 0.10 0.05

Loss RM0 RM20,000 RM40,000

a) Calculate the expected value and standard deviation of Ahmad’s losses for the year.
Expected value = Σ Ri * Pi
= (RM0 x 0.85) + (0.10 x RM20,000) + (0.05 x RM40,000)
= RM 4,000

Loss Probability Loss outcome - (Loss outcome - (Loss outcome -

expected expected loss)^2 expected loss)^2 x
loss( RM4000) probability

RM0 0.85 -RM 4,000 RM 16,000,000 RM 13,600,000

RM20,000 0.10 RM16,000 RM 256,000,000 RM 25,600,000

RM40,000 0.05 RM36,000 RM 1,296,000,000 RM 64,800,000

Variance= RM
104,000,000
Standard deviation = √ RM 104,000,000
= RM 10,198.04

b) Assume that Ahmad pools his losses with Bakar’s store, which has an identical loss distribution.
Bakar’s losses are independent of Ahmad’s. Ahmad and Bakar agree to split the total losses in the
pool equally. Show the revised probability distribution for the mean loss from the pool.

Ahmad loss Bakar loss Total loss Mean loss Probability

RM0 RM0 RM0 RM0 0.85x0.85=0.7225

RM20,000 RM0 RM20,000 RM10,000 0.1x0.85= 0.085

RM0 RM20,000 RM20,000 RM10,000 0.85x0.1=0.085

RM20,000 RM20,000 RM40,000 RM20,000 0.1x0.1=0.01

RM40,000 RM0 RM40,000 RM20,000 0.05x0.85=0.0425

RM0 RM40,000 RM40,000 RM20,000 0.85x0.05=0.0425

RM20,000 RM40,000 RM60,000 RM30,000 0.1x0.05=0.005

RM40,000 RM20,000 RM60,000 RM30,000 0.05x0.1=0.005

RM40,000 RM40,000 RM80,000 RM40,000 0.05x0.05=0.0025

Mean loss RM0 RM10,000 RM20,000 RM30,000 RM40,00

outcome 0

Probability of 0.7225 0.085+0.085 0.0425+0.0425+0. 0.005+0.005=0.01 0.0025

mean loss = 0.17 01 = 0.095

c) Based on your answers in part (a) and (b) above, calculate the expected value and standard
deviation of the pooled mean losses.

Expected value of the pooled mean losses

= Σ Ri * Pi
=(0.7225x0)+(10,000x0.17)+(20,000x0.095)+(30,000x0.01)+(40,000x0.025)
=RM4,000
Mean loss Probability Loss Outcome- Square difference Squared differences x
outcome Expected loss Probability

RM0 0.7225 RM-4,000 RM16,000,000 RM11,560,000

RM10,000 0.17 RM6,000 RM36,000,000 RM6,120,000

RM20,000 0.095 RM16,000 RM 256,000,000 RM24,320,000

RM30,000 0.01 RM26,000 RM676,000,000 RM6,760,000

 RM40,000 0.0025 RM36,000 RM 1,296,000,000 RM3,240,000

1 Variance= RM52,000,000

Standard deviation=√ Variance

=√ RM52,000,000
= RM7,211.1

4. Anitha owns Smart Kiddies Centre. Based on discussions with risk consultants, other education
providers and attorneys, she estimated that she has a 4% chance of losing a RM150,000 lawsuit in
the next year, compared to a 96% chance that she will not be sued.

Required:
(a)
Probability Loss Outcome (RM)

0.96 0

0.04 150,000
Estimate a loss distribution for Smart Kiddies Centre.

(b) Calculate the expected value and standard deviation of Smart Kiddies Centre’s loss for the
year.

Expected value / loss

= (RM0 X 0.96) + (RM150,000 X 0.04)
= RM6,000
The expected loss of Smart Kiddies Centre and Anitha will be RM6000.

Loss outcomes Probabilities Loss outcomes - (Loss outcomes - (Loss outcomes -

(RM) Expected loss Expected loss)^2 Expected loss)^2
x Probability

0 0.96 RM0 - RM6000 = - -RM6000 ^2 RM34,560,000

RM6000 =RM36,000,000

150,000 0.04 RM150,000- RM144,000^2 RM829,440,000

RM6000 =RM20,736,000,00
=RM144,000 0

Variance=
RM864,000,000

Standard deviation
= √RM864,000,000
 = RM29,393.88
In conclusion, the standard deviation for Smart kiddies centre will be RM29393.88

© Aniitha agrees to pool her risk with Belinda, the owner of Bright Spark Centre. It is assumed that both
Anitha and Belinda have homogeneous risk characteristics, i.e. they exhibit the same level of risk,
represented by Anitha’s liability loss distribution estimated in part (a) above. In addition, each pool
member’s loss experience is statistically independent of the other member’s, and each person entering
the pool agrees to pay the mean loss of the pool.

i. Estimate the revised probability distribution for the mean loss from the pool.

Anitha’s loss Belinda’s loss Total loss (RM) Mean loss(RM) Probability
(RM) (RM)

0 0 0 0 0.96 x 0.96 =
0.9216

150,000 0 150,000 75,000 0.96 x 0.04 =

0.0384

0 150,000 0 75,000 0.04 x 0.96 =

0.0384

150,000 150,000 300,000 150,000 0.04 x 0.04 =

0.0016

Mean loss outcome RM0 RM75,000 RM150,000

Probability of mean loss outcome 0.9216 0.0768 0.0016

[Link] the expected value and standard deviation of the pooled mean losses.
(BBMF2083 Examination, Question 2, Aug 2015)

Expected value of the pooled mean losses

= Σ Ri * Pi
= (RM0 x 0.9216) + (RM75,000 x 0.0768) + (RM150,000 x 0.0016)
= RM6,000

Loss outcomes Probabilities Loss outcomes - (Loss outcomes - (Loss outcomes -

(RM) Expected loss Expected loss)^2 Expected loss)^2 x
Probability

0 0.9216 -6,000 36,000,000 33,177,600

75,000 0.0768 69,000 4,761,000,000 365,644,800

150,000 0.0016 144,000 20,736,000,000 33,177,600

 1 Variance = 432,000,000

Standard deviation of the pooled mean losses

= √ Variance
= √ RM432,000,000
= RM20,784.61