Risk Management and Insurance

UNIVERSITY OF DHAKA
EMBA, FINANCE
Submitted By:-
Md.Ziauddin ID#15006
Submitted to:-
Prof. Dr. Baqui Khalily
 Problem No. 10
You are informed that you have just received an
inheritance 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 of
drawing balls from a bowl containing 90 black
balls and 10 white ones. If you draw a black ball,
you receive $ 1,000; if you draw a white ball, you
receive $ 100,000. Which choice would you take
and why? Explain how this situation illustrates the
economic burden of risk.

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Solution of the Problem #10
Generally human beings are risk averse. Business as well as individuals may try
either to avoid risk of loss as much as possible or to reduce its negative
consequences.
Among choice (a) and (b) I would take choice (a); because this choice is risk
free and provide me $10,000 without any hazard.
Choice (b) has highly possibility of loss. So it is risky choice. Among 100 balls
only 10 balls are white and the rest 90 balls are black. The probability of
picking up one white ball from 100 balls (without seeing) is 0.1 i.e. 10%. On
the 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 $1,000
means I will lose $9,000 [10000-1000]. But if I can pick up a white ball it will
give 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 the
largest potential returns are associated with the riskiest venture. This is called
the economic burden of risk. Here option (b) illustrates the economic burden of
risk. This venture will give me largest return of $100,000 and is associated with
highest 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 never
experiences 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 greater
objective risk? Who has the greater chance of
loss? Explain.

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Solution of the Problem #11
The consequences of fire are severing, so the highest number of fire is
highest expected loss. We know the formula for calculating “Objective
risk” = Variation in loss/Expected Loss.
Company A’s 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 means
0 and highest number of fire is 3 i.e. expected highest loss.
Company B’s Objective risk = [(30-24)/36] = 6/36=1/6= 0.1666
means 16.67%, as average number of fire is 30 per year, never has
fewer than 24 means lowest loss 24 and highest number of fire is 36
i.e. expected highest loss.
The risky ness of company ‘B’ is low but the severity of risk is 12
times (3:36) higher than company ‘A’. In fire company A’s only
highest 3 buildings will be effected and some times none will be
effected on the other hand company B’s highest 36 buildings will be
effected and at least 24 will be effected. So, company B has greater
chance of loss.

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Problem #13
Why is variation used as a measure of the
degree of risk instead of another measure
such as the expected annual loss? Explain
why there is a higher degree of risk if the
probability of the occurrence of a loss is 80
percent than if the probability of a loss is 99
percent. At what two probabilities of the
occurrence of an event would you expect
risk to totally disappear? Explain.
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Solution of the Problem #13
We know that any event that is measurable based on historical
data 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 not
occurring of an event. The degree of risk is the relative
variation of actual from expected loss and formula is “Probable
Variation of actual from expected Losses/Expected Losses”. If
a loss has already occurred, the probable variation of actual
from 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 is
zero and the degree of risk is zero as well. Expected annual
loss is a extreme point probability, the degree of risk for this
will be zero. This is why variation used as a measure of the
degree of risk instead of another measure such as the expected
annual loss.
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Solution of the Problem #13 (cont.)
There is a higher degree of risk if the probability
of 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 percent
probable occurrence is higher than 99 percent
probable occurrence. For example- 99%
probability of making defective glasses in a glass
factory has low risk of loss in compared with
0.1% 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 terms
of a group large enough to analyze statistically. If the numbers
involved are very small, then the range of probable variation may be
so 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 product
development department. Company A has been informed that Mr. X’s
probability of dying during next year is 0.3 percent and the chance of
loss due to the peril of death is 0.003. The degree of risk is not
particularly meaningful, however when applied only to Mr. X’s 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 occurrence
of an event would expect risk to totally disappear.

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Risk Management and Insurance Assignment

Thank you!