Topic 7 Selecting Risk Management Alternatives Loss Matrix Firm A Revenue 2 000 Insurance 0 Taxable Income 2 000 Tax Bill of 40 Tax 800 Firm B Revenue 2 000 Insurance Premium 400 Taxable Income 1 600 Tax 640 Loss Fire All or nothing no partial loss o Building worth 254 000 No Loss No Fire Possible Risk Management Alternatives for Insuring Building Retention Funded Internally 254 000 Retention Safety Measures 254 000 7 200 261 600 Full Insurance Coverage 254 000 Premium 12 000 Probabilities Without Safety o Probability of Fire 3 o Probability of No Fire 97 With Safety o Probability of Fire 1 o Probability of No Fire 99 1 Expected Loss for each Option a Retention i 254 000 0 03 0 0 97 7 632 b Retention Safety i 261 000 0 01 7 200 0 99 9 744 c Full Insurance 12 000 If the decision is to choose among Risk Management Alternatives in this case o Choose lowest priced option Retention 2 Types of Cost 1 Monetary Cost 2 Non Monetary Cost Expected Loss Cost of Uncertainty Worry Value Worry Value o Cost associated with decision making Cost of anxiety loss of sleep Unique to the decision maker Estimate Worry Value for retention Loss Probability 254 000 0 03 0 97 0 buy full insurance for a fair premium o Example Offer Key decision maker a choice between Retention that has a P of 7 632 or 7632 10 20 How far do you go When do you stop Maximum Pmax Maximum premium that a person or a firm is willing to pay for a particular risk o Formula Pmax P Worry Value Worry value is Maximum amount over and above P that a person is willing to pay to reduce uncertainty
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