Risk Management and Insurance Assignment 01

8/9/2019 Risk Management and Insurance Assignment 01

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Risk Management and Insurance

UNIVERSITY OF DHAKA

EMBA, FINANCE

Submitted By:-Md.Ziauddin ID#15006

Submitted to:-

Prof. Dr. Baqui Khalily


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Problem No. 10

You are informed that you have just received aninheritance from a great uncle who was something

of the eccentric. You have your choice of (a)

taking $10,000 in cash or (b) joining in a game ofdrawing balls from a bowl containing 90 blackballs and 10 white ones. If you draw a black ball,you receive $ 1,000; if you draw a white ball, youreceive $ 100,000. Which choice would you take

and why? Explain how this situation illustrates theeconomic burden of risk.


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Solution of the Problem #10

Generally human beings are risk averse. Business as well as individuals may tryeither to avoid risk of loss as much as possible or to reduce its negativeconsequences.

Among choice (a) and (b) I would take choice (a); because this choice is riskfree and provide me $10,000 without any hazard.

Choice (b) has highly possibility of loss. So it is risky choice. Among 100 ballsonly 10 balls are white and the rest 90 balls are black. The probability ofpicking up one white ball from 100 balls (without seeing) is 0.1 i.e. 10%. Onthe other hand, the probability of picking up one black ball from 90 balls(without seeing) is 0.9 i.e. 90%. In picking up black ball results only $1,000means I will lose $9,000 [10000-1000]. But if I can pick up a white ball it willgive me $100,000 but this probability is 9 times less than to pick up a black

ball. So my choice is for option (a).Economic Burden of risk: Risk bearing is tantalizing. It is assumed that thelargest potential returns are associated with the riskiest venture. This is calledthe economic burden of risk. Here option (b) illustrates the economic burden ofrisk. This venture will give me largest return of $100,000 and is associated withhighest risk of 90%.


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Problem #11

Company A owns 100 buildings and averages 2

fires per year. Company B owns 1,000 buildings

and averages 30 fires per year. Company A neverexperiences more than 3 fires a year, although in

some years there are none. In some years

Company B has as many as 36 fires but never has

fewer than 24. Who is faced with the greaterobjective risk? Who has the greater chance of

loss? Explain.


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The consequences of fire are severing, so the highest number of fire ishighest expected loss. We know the formula for calculating Objectiverisk = Variation in loss/Expected Loss.

Company As Objective risk = [(2-0)/3] = 2/3= 0.67 means 67%, as

average number of fire is 2 per year, in some year there is none means0 and highest number of fire is 3 i.e. expected highest loss.

Company Bs Objective risk = [(30-24)/36] = 6/36=1/6= 0.1666means 16.67%, as average number of fire is 30 per year, never hasfewer than 24 means lowest loss 24 and highest number of fire is 36i.e. expected highest loss.

The risky ness of company B is low but the severity of risk is 12times (3:36) higher than company A. In fire company As onlyhighest 3 buildings will be effected and some times none will beeffected on the other hand company Bs highest 36 buildings will beeffected and at least 24 will be effected. So, company B has greaterchance of loss.


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Problem #13

Why is variation used as a measure of thedegree of risk instead of another measure

such as the expected annual loss? Explainwhy there is a higher degree of risk if theprobability of the occurrence of a loss is 80percent than if the probability of a loss is 99

percent. At what two probabilities of theoccurrence of an event would you expectrisk to totally disappear? Explain.


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We know that any event that is measurable based on historicaldata is risk. It can vary in between 0-1 on the basis of

probability. 0 is negative certainty and 1 is positive certainty.The 0 and 1 is the two extreme points of occurring and notoccurring of an event. The degree of risk is the relativevariation of actual from expected loss and formula is ProbableVariation of actual from expected Losses/Expected Losses. Ifa loss has already occurred, the probable variation of actualfrom expected losses in that particular situation is zero and,therefore degree of risk is zero. At the opposite extreme, if it is

impossible for a loss to occur, the probable variation also iszero and the degree of risk is zero as well. Expected annualloss is a extreme point probability, the degree of risk for thiswill be zero. This is why variation used as a measure of thedegree of risk instead of another measure such as the expectedannual loss.


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Solution of the Problem #13 (cont.)

There is a higher degree of risk if the probabilityof the occurrence of a loss is 80 percent than if the

probability of a loss is 99 percent because the

severity of loss or the extent of loss in 80 percentprobable occurrence is higher than 99 percentprobable occurrence. For example- 99%probability of making defective glasses in a glass

factory has low risk of loss in compared with0.1% probability of making defective drug in a

pharmaceutical company.


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Solution of the Problem #13 (cont.)

In measuring the degree of risk, results are meaningful only in termsof a group large enough to analyze statistically. If the numbersinvolved are very small, then the range of probable variation may beso large as to seem virtually infinite when viewed in a relative sense.For example Company A is concerned about the possible death of Mr.X, a valuable, highly paid 24-year-old worker in its productdevelopment department. Company A has been informed that Mr. Xsprobability of dying during next year is 0.3 percent and the chance ofloss due to the peril of death is 0.003. The degree of risk is notparticularly meaningful, however when applied only to Mr. Xs life.Either Mr. X will die or she will not, making the relative variation of

actual from expected losses extremely large: [(1-0)/0.003]= 333.33=33, 333 percent. In these sense two probabilities of the occurrenceof an event would expect risk to totally disappear.


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Risk Management and Insurance Assignment

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Risk Management and Insurance Assignment 01