Risk Management

utility and decisions
If we have a utility function that translates from dollars to utility, how do we use it in making a decision? The idea of utility is that it should help us choose among alternatives with uncertain outcomes—that is, alternatives that are risky—by capturing our attitudes toward risk. If I were risk neutral and willing to make decisions based on expected monetary value, my decision trees should use expected money as the criterion for the best alternatives. Utility theory says that I should be using expected utility as the criterion in order to capture what for most of us is risk aversion.

Consider an investment decision. You have three choices: (1) a high-risk investment, (2) a low-risk investment, or (3) keeping your money in the bank without risk. If the market goes “up,” the high-risk investment returns $1500 but the low-risk investment only returns $1000. Similarly for the other uncertain outcomes shown in the decision tree below. The market can go up, down, or stay the same. The bank account is unaffected by the market. The corresponding probabilities of each outcome are shown. The expected monetary values (EMV) of the three alternatives are +$580, -$200, and $500, respectively.

Dollar value

Utility

$1500

1.00

1000

0.86

500

0.65

200

0.52

100

0.46

-100

0.33

-1000

0.00

The table on the right-hand side are the utility values you have assessed for yourself. What is your best alternative from an expected utility perspective? Compare this with the best alternative from EMV. Explain the difference, if any.

Risk transfer
Explain the purpose of reinsurance including, spreading risk, capacity, financial security, and capital management. Explain the difference between reinsurance and retrocession. Discuss alternatives to conventional reinsurance. Limit your answer to one page.

Place your bets
Here you also have an opportunity to earn extra credit. Select whether you want three (3) extra points or six (6) extra points added to your final score. You will receive what you choose.

Image result

Which do you want?

☐ Six points

☐ Three points

☐ None (I refuse to play)

But! There is a small catch: if more than 15% of the class (3 people) select six points, then those who do choose six points will get minus 2 points, and those who choose three points will get minus 1 point. Please don’t communicate your choice to others in the class! That would be cheating.

Explain your analytical thinking (this accounts for the original 33 points of this problem … the +3 or +6 are in addition).

John von Neumann, the father of Game Theory, Utility Theory, and Monte Carlo Simulation Method

Draw on the many things you learned this semester in ENCE 627 to structure your argument.

Among whatever else you include, please cite considerations of …

· Human or psychological factors,

· Probability estimates and calculations,

· Risk and decision analysis, and

· Risk management factors

which form the basis for your thinking and how they influenced each of your decisions.

Be specific. Cite concepts and references as needed to support your argument. Show your calculations.

High Risk

Low Risk