Question

1.         A firm is considering self insurance for its workers compensation exposure for the next five years. From past experience, it is believed that gross claims outlays are $600 a year per employee (i.e. expected loss). These are assumed to be payable as follows: 35%, 30%, 20%, 10%, and 5% in the first through fifth years respectively. If the firm self-insures, administrative costs are $400 per employee annually. Full and complete insurance is available for a premium of $1000 per covered employee per year. The firm currently has 1000 employees for which it wishes to obtain coverage.

Should self-insurance be adopted as an alternative to full insurance for the next five years? Why or why not?

Other information and assumptions:

            Tax rate - 50%

            Interest rate - 7%

            All insurance premiums are paid at the beginning of the year.

            All losses and administrative costs are payable at the end of the year.

            Tax deductions are realizable when the tax deductible expenditures are paid.

            Note: Although losses will still be paid out through year 9 under the self-insurance option,

                        administrative expenses are only paid for the first 5 years.

Answer 1

Firm should adobt self insurance as an aternative, as self insurance provides NPV of $16,517 then full insurance.

Total cash outlay will be same, but full insurance have more initial cash outlay.

Please refer attached excel screen shot for calculation.