Risk Management 2 Utility and Decisions
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Risk Management 2 Utility and Decisions
utility and decisions
If we have a utility function that translates from dollars to utility, how do we use it in deciding? 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.
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
Bank
Up
Down Same
Up
Down Same
RUBRIC
Excellent Quality
95-100%
Introduction 45-41 points
The background and significance of the problem and a clear statement of the research purpose is provided. The search history is mentioned.
Literature Support
91-84 points
The background and significance of the problem and a clear statement of the research purpose is provided. The search history is mentioned.
Methodology
58-53 points
Content is well-organized with headings for each slide and bulleted lists to group related material as needed. Use of font, color, graphics, effects, etc. to enhance readability and presentation content is excellent. Length requirements of 10 slides/pages or less is met.
Average Score
50-85%
40-38 points
More depth/detail for the background and significance is needed, or the research detail is not clear. No search history information is provided.
83-76 points
Review of relevant theoretical literature is evident, but there is little integration of studies into concepts related to problem. Review is partially focused and organized. Supporting and opposing research are included. Summary of information presented is included. Conclusion may not contain a biblical integration.
52-49 points
Content is somewhat organized, but no structure is apparent. The use of font, color, graphics, effects, etc. is occasionally detracting to the presentation content. Length requirements may not be met.
Poor Quality
0-45%
37-1 points
The background and/or significance are missing. No search history information is provided.
75-1 points
Review of relevant theoretical literature is evident, but there is no integration of studies into concepts related to problem. Review is partially focused and organized. Supporting and opposing research are not included in the summary of information presented. Conclusion does not contain a biblical integration.
48-1 points
There is no clear or logical organizational structure. No logical sequence is apparent. The use of font, color, graphics, effects etc. is often detracting to the presentation content. Length requirements may not be met
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