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Exploring the Principles of Portfolio Theory in Corporate Risk Management of Hazards and the Four Main Elements of an Insurance Premium

Jun 3, 2023 | 0 comments

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Jun 3, 2023 | Essays | 0 comments

(2) Sketch the general shape of the probability distribution of damage for a single asset of your choice Label the axes of your graph and include notes to explain aspects of the shape of the distribution.

In most complex systems, the predictable unpredictability is the common feature. This seems to be contradicting but it is evident in natural calamities. The natural calamities in corporate such as building getting burnt present a similar curve and can be gotten by plotting the event probability on the y axis against the occurring event consequences or its severity on the x axis (Holmes 2002p.56)

In a situation where a building gets burnt, there is high probability that a building will get burnt down in a factory or a company especially if electricity is used. But the majority of the burns will be inconsequential and small. The curve that will be obtained by plotting the frequency of the burns against the magnitude of the burns exhibits the power law behavior that can be applied to explore different variations in building burns.

It is not possible to give a prediction where the next building will burn due to random electrical failures and even unforeseen calamities. The horizontal axis is the percentage of the damage and the vertical axis is the probability of the building getting burnt (Merna et al 2008 p.109).


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(3) Explain and provide examples of how the following principles from portfolio theory apply to corporate risk management of hazards

  • Positive correlation principle
  • Zero correlation principle
  • Negative correlation principle

According to Crouhy et al (2008 p.228), modern portfolio theory controls financial threat through diversification. Modern portfolio theory is not able to consideration for trader activities, depends on traditional activities of threat without searching its causes, and uses elegant but wrong Gaussian models. These restrictions limit Modern portfolio theory projects to catastrophe law because most occurrences follow non-Gaussian withdrawals. Actions propensities in threat understanding seriously change legal reactions to occurrences. I shall nevertheless offer Modern portfolio theory as a basis for analyzing catastrophe law and policy.

Modern portfolio theory represents that traders are threat adverse. Make up follows risk; traders demand a higher expected rate of return for higher threat or risk. As one proxy beta servers for threat, try out investigates income on a resource or a consideration with a wider benchmark. The correlation principle of resource activities like the; (1) the covariance between that asset’s variety of come coming back and the whole portfolio’s variety of return rate, (2) separated by the distinction of income on the portfolio (Shimpi 2001p.69):

Zero correlation principle indicates a lack of connection between a resource and its benchmark. Negative correlation principle indicates inverse correlation; useful industry activity means a loss in value for the resource, and vice versa (Chew 2008p.175). The essay will focus on useful ideas for correlation principles. Although correlation has no upper or lower limited, a correlation of 1 indicates a resource whose systemic volatility, or understanding to threat or risks, is the same as that of the wider industry. Positive correlation values below 1 — that is, 0 < β < 1 — indicate a resource that goes along with the wider industry, but is less unexpected. Values higher than 1 indicate higher activities (Vaughan 1997p.339)

Correlation principles work a critical role in the capital resource costs model. The CAPM provides come coming back as a function of threat and the top quality for activities over a benchmark set by a risk-free investment:

(4) Describe briefly the four main elements of an insurance premium

According to Scott (2007p.116)The premium amounts are quickly identified depending on the policy of subscription up or commercialization of each insurance firm, for which objective all or some of the following aspects are taken into consideration:

Model or trademark of the vehicle: These are important aspects. The top quality for transport protection is measured depending on the loss event and the secured sum or value of the automobile.

Use of the vehicle: The use or success of the automobile has an immediate impact on the policy cost. It is not the same as a cab than a personal car. Furthermore, some insurance firms consider the approximated yearly miles, namely, the greater the miles, the greater the costs.

Geographical location: loss statistics shows that there are different risk locations. In common, they are categorized in High, Medium and Low Risk Zones mainly in interest to the inhabitants and automobile traffic density (Doherty 2000p.220).

In addition, insurance firms could consider other data:

Public place of the insured: For example, it must be described that, from a mathematical perspective, the extensive variety of statements is decreased among couples.

Sex and age: According to worldwide research, men and in particular, young men, have a bigger extensive variety of injuries, and in the impact, they use to pay greater costs.

(5)Explain how the elements of an insurance premium described in question 4 are influenced by the following factors.

1. The insured expected losses

In an agreement where the insured and the insurance company is in agreement to take an insurance cover may influence the premium rates and amounts. If the unexpected losses that are insured are of high magnitude, the premium rates will be high. This is in contrast to situations where the expected losses are low which will incur low premium amounts (Scott p.46).

2. Potential variation around the insured’s expected losses

Mars et al (2000) pointed out that people look for protection. A feeling of protection may be the next primary objective after meals, outfits, and shelter. A person with cost-effective protection is pretty certain that he can fulfill his needs (food, shelter, health care, and so on) in the present and later on. Economical or risk is the possibility of dropping cost-effective protection. Most cost-effective threat derives from difference from the predicted result. These variations may either increase or decrease the rate of premiums.

3. Risk sharing arrangements between insured and insurer

A risk sharing agreement is agreed upon between an insurer and the insured to share the risks. This tends to lower the premiums rates as the insured bears some of the risks. This is evident in some of the least risks experiences by the insured.

4. Insurer’s portfolio construction activities

According to Holmes (2002p.83), each country has a commissioner for insurance who is responsible for activity regular ion of all the insurance companies. People always rely on the insurance companies for their financial planning. Lack of some critical reinsurance coverage, it may leave individual insurers with short term with workers compensation and commercial property from potential event above risks of higher levels. This may eventual leads to a rise in the premium rates

5. The insurers cost of administration

If the insurance company has high cost of administrations that is evident in their daily operations and expenditure, this is likely to have an effecting the rate of premiums. For instance, an insurance firm that operates with many employees wills most likely charge higher premiums on their policies to maintain and even run their operations (Merna et al 2008p.190).

6. Insurance market trends

According to Crouhy et al (2000p. 95), the underwriting design is the propensity of property and sufferer insurance premiums, income, and availability to protection to go up and down with some regularity over time. A design begins when insurance firms restrict their underwriting specifications and significantly increase expenses after a period of serious underwriting problems or negative shares to cost-effective commitment (e.g., cost-effective commitment losses). More highly effective specifications and higher premiums lead to a development of income and build up of cost-effective capital accumulation. The improvement in underwriting potential improves competitors, which in turn drives premiums down and relaxes underwriting specifications, thereby resulting in underwriting problems and creating the level for the design to begin again

(7) List the key factors which determine the costs of an organizations retained risk

  1. Expected losses
  2. Insurance purchased
  3. Profitability of the risk assumption
  4. Sales projections
  5. Shareholders profit expectations
  6. Cash flow requirements
  7. Accounting and Legal tax position
  8. Loan covenants
  9. Predictability of some insurance risks
  10. Charge to be incurred when the risk is transferred to an insurance company
  11. Type of coverage
  12. Amount of the premiums to be paid
  13. Expensiveness of documenting and settling of all losses
  14. Adverse future effect on insurance costs
  15. Existing deductibles applicable to the portions of the property existing
  16. Self insured retention on certain liability coverage
  17. Lack of insurance coverage on different catastrophes like earthquakes
  18. Measure of materiality of the net income before taxation
  19. Ability of the company to fund quickly an unexpected loss
  20. Long term financial ability of the company to absorb loss
  21. Ability of the company to cover sudden emergencies using assets that can quickly be converted to cash

(8) Explain the relationship (direction (+ or -) and strength (weak/indirect or strong/direct) between any variables listed in 7 which are interrelated in some way

The expected losses and the insurance purchased have a strong relationship which makes them have positive strength. Furthermore, the expected losses relationship with has indirect relationship with profitability of the risk assumption and the charge to be incurred when the risk is transferred to an insurance company.

Shimpi (2001p.26) pointed out that the insurance purchased by a company has also a direct relationship with profitability of the risk assumed by the company. This will in turn have a positive and strong relationship with the sales projection of the company and the shareholders profit expectations.

Cash flow requirements for a company to retain risked is also related to the accounting an legal tax position of the company. The loan covenants are indirectly related to the predictability of some of the insurance risks. The charge to be incurred when the risk is transferred to an insurance company has a positive relationship with type of coverage and the amount of the premiums to be paid.

The expensiveness of documenting and settling of all losses, on the other hand, has a direct relations hip with adverse future effects on insurance costs. This positive strength is further shown in existing deductibles applicable to the portions of the property existing and the self insured retention on certain liability coverage (Chew 2008p.117).

Lack of insurance coverage on different catastrophe like the earthquakes, wars and the floods portrays an indirect and strong relationship with measure of materiality of the net income before taxation. Similarly, the ability of the company to fund quickly an expected loss positively correlate with the ability of the company to cover sudden emergencies using assets that can quickly be converted to cash.

(9) Provide an equation for an organization’s total cost of pure risk

Doherty (2000p.71) observed that the risk involved in conditions that present the chance of reduce but no potential for obtain. Authentic threats and risks are generally insurable. A pure risk is a type of risk in which loss is the only possible outcome; there is no useful result. Authentic risks are related to activities that are beyond the risk-takers control and, therefore, a person cannot deliberately take on genuine threat.

Risks are Situation where there is plausible of either loss or no loss, but no potential for gain. Only genuine risks are insurable because otherwise (where the chance of the incident of a loss is determinable) insurance plan policy is similar to gambling and the secured may stand to obtain from it a scenario contrary to the most essential idea of insurance.

Risk is a trader’s doubt about the financial benefits or issues that will result from particular investment (Vaughan 1997p.228). Income are often calculated in terms of bookkeeping numbers such as return on assets, return on sales and return on equity. Income can also be calculated on the reasons for inventory return on income such as per month earnings (the end of the period inventory cost without the starting inventory cost separated by the starting inventory cost, creating amount return). Earnings per share are another means to evaluate overall performance. Loss of costs, costs and issues increases income thereby creating value for the traders. More traders would mean more career development and growth viewpoint at the Economic Area.

The equation of cost of pure risk is below:

COST OF PURE RISK =COST OF CONTROL +COST OF FINANCING (cost of insurance premium, transfer of financing, extra costs with contract. Cost of running a fund cost of loan).


Scott E. Harrington, (2007) Risk Management and Insurance. 2nd Edition. McGraw-Hill

Holmes, A. (2002) Risk management. Oxford, U.K., Capstone Pub.  Retrieved from http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=67239.

Merna, T., & Al-Thani, F. F. (2008) Corporate risk management. Chichester, England, Wiley. Retrieved from http://public.eblib.com/EBLPublic/PublicView.do?ptiID=470193.

Crouhy, M., Galai, D., & Mark, R. (2000) Risk management. New York, McGraw Hill. Retrieved from http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=52252.

Shimpi, P. A. (2001) Integrating corporate risk management. New York, Texere.

Chew, D. H. (2008) Corporate risk management. New York, Columbia University Press.

Vaughan, E. J. (1997) Risk management. New York, John Wiley.

Doherty, N. A. (2000) Integrated risk management techniques and strategies for managing corporate risk. New York, McGraw-Hill. Retrieved from http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=52276.

Mars, G., & Weir, D. (2000) Risk management. Aldershot, Hants, England, Ashgate.

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