Loss Dependence – A Portfolio Level View of Retained Exposures
By Jason Flaxbeard, Aaron Newhoff, and Andrew Golub
This is the second white paper in this series. If you missed the first paper, you can download a copy here. To demonstrate the importance of dependence between risks, we once again utilize a highly simplified corporate case study.
White paper 1: Beyond Expected Value – Considering Volatility
White paper 2: Loss Dependence – A Portfolio Level View of Retained Exposure
White paper 3: Corporate Risk Appetite and Program Structuring
COMPANY ABC ILLUSTRATIVE CASE STUDY
In our first paper, we reviewed how expected value is inadequate as a standalone measure of risk, and we made the case that loss volatility should also impact risk financing decisions. In the following example,we examine how correlations among risks may impact the overall volatility of an entity’s retained loss exposure.
Large risk bearing organizations are typically concerned with more than one potential cause of loss or line of insurance coverage; however, we frequently see individual exposures considered in isolation with minimal regard for how correlation may impact the overall corporate risk profile. The simplified case below illustrates the impact that the consideration of dependence may have on a risk financing decision making process.
Company ABC is assessing the risk associated with two exposures: Risk X and Risk Y. Risk X is larger than Risk Y in expected value terms, but Risk Y possesses a proportionally larger amount of volatility.