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: Retention Retention plus loss control 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: Partial InsuranceFace amount of the policy = $200,000Premium = $75,000 Deductible Insurance Face amount of the policy = $1,000,000Deductible = $100,000Premium = $110,000 Full Insurance Face amount of the policy = $1,000,000Premium = $150,000
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