Answer to Question #286400 in Financial Math for Trissmith

Question

Mr. Banabashi has a house, worth €180,000. He is concerned with earthquake risk and wishes to insure his property. It is known that either there is a rare chance of one in 10,000 of an earthquake causing the house to be destroyed completely. Or there is a more common chance of 1 in 100 of an earth trimmer causing discomfort.

His daughter, Bimianeh who is a student of ECO College of Insurance suggests his father should sell half share of his property and buy a half share of another property with equal earthquake risk. This, she argues will pool his risks. But she has difficulty convincing his father about this. They approach you for consultation.

(a) What would you say to them?

(b) Who do you think is right and why?

Answer 1

Solution:

A. The advice of Bimianeh is not genuine at all, this will not reduce or diversify the risk, rather the risk will remain same. My suggestion for them will be to sell the half of the property which will be of value €90,000 and should buy other property with no earthquake risks, this will diversify their risk as when the earthquake occurs and the earthquake prone property gets damaged, they will still have the new property safe which is not located in a earthquake prone area.

This is the same when we invest in a portfolio of stocks containing risky as well as risk free stocks which balance the amount of risk on the whole. The risk of earthquake cannot be avoided as a systematic risk but it can be diversified as above. The advice of his daughter will not reduce any risk, rather when the earthquake occurs both the properties will face damages whatever the probability of getting damaged will be.  

B. Mr. Banabashi is right here but only upto a certain extent as he is not suggesting a better alternative over what his daughter is suggesting.