RISK MANAGEMENT HOMEWORK
1. A small company owns a $75,000 company car. If there is a loss, it is a total loss.
The company’s probability distribution for losses is estimated as follows:
Loss ($) Probability
0 .9
$75,000 .1
The risk manager is considering three options to manage this risk:
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Retention
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Retention plus loss control
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Full insurance at an annual premium of $8,300
The loss control measure costs $3,500. Using the loss control measures is expected
to result in the following loss distribution:
Loss ($) Probability (with loss control)
0 .95
$75,000 .05
a. Construct an after-tax loss matrix. Assume that the firm’s tax rate is 30%. (6
points)
b. Suppose the risk manager’s decision rule it to minimize after-tax expected
loss. Which risk management alternative will she choose? (2 points)
c.
Assume that the risk manager has a worry value (WV) equal to $2,000 for
retention. Assume also that the WV for retention with loss control is $1,000.
If the risk manager decides to
minimize TOTAL COST
, what risk
management alternative does she choose? Show all total cost calculations
and work and explain why the risk manager selects the option. (2 points)
2. Assume a firm owns a $1,000,000 office building with the following probability
distribution related to property losses:
Loss ($) Probability of the loss
0 .65
200,000 .25
600,000 .08
1,000,000 .02
The firm would like to purchase insurance for this risk and is considering the
following three different insurance alternatives:
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Partial Insurance
Face amount of the policy = $200,000
Premium = $75,000
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Deductible Insurance
Face amount of the policy = $1,000,000
Deductible = $100,000
Premium = $110,000
ï‚·
Full Insurance
Face amount of the policy = $1,000,000
Premium = $150,000
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