Risk Management

1.Assume a firm owns a small airplane worth $700,000.

Assume initially that the plane is subject to the risk of physical damage. They believe that the probability of loss is 3%. Also assume that when a loss occurs, it will be a total loss. Assume this firm%u2019s marginal tax rate is 35%.

The firm has four current risk management options to use to manage this risk.

[1] The firm can purchase full insurance for the risk of physical damage/destruction to this plane for a premium of $22,000.

[2] The firm is also considering retention as an alternative to full insurance.

[3] The firm is considering a loss control measure (LC) to use in conjunction with both retention and full insurance.

The cost of loss control is $3000

The impact of loss control is to reduce the probability of loss from 3% to 2%.

The insurer agrees to reduce the insurance premium from $22,000 to $17,000 if/when the loss control measure is introduced.

a.Construct an after tax loss matrix. Assume that the firm%u2019s marginal tax rate is 35%.

b. Suppose the risk manager wants to minimize expected loss as her decision rule. What risk management alternative does she choose? Show all expected loss calculations and work and explain why the risk manager chooses the option.

c.Assume that the risk manager has a worry value (WV) equal to $5,000 for retention. Assume also that the WV for retention falls to $4,000 when the probability of the loss falls due to the loss control measure, (i.e., the WV for retention with loss control is now equal to $4,000.)

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.

 

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