Question
In: Finance
1: Ellis Company owns a small office building worth $300,000. Cameron is the risk manager. Ellis...
1: Ellis Company owns a small office building worth $300,000. Cameron is the risk manager. Ellis faces the risk of fire which would completely destroy their building. The probability of a fire is known to be 3%.
Cameron is considering the following risk management options to address the risk of fire to their building:
a. Retention
b. Full Insurance for a premium of $10,000
c. Safety Program & Retention
d. Safety Program & Full Insurance (premium falls to $8,000)
The cost of the Safety Program is $1,500. It has the impact of lowering the probability of a fire from 3% to 2%. However, if a fire does occur, it is still a full loss.
Imagine the federal government instituted a $1000 “mandate" for full insurance. That is, Ellis Company must pay a penalty of $1000 if they do not purchase full insurance. How would this affect Cameron's PMAX?
Please explain how to solve this
Solutions
Expert Solution
| A / 1 | B | C | D | E | F |
| 2 | Ellis Company | ||||
| 3 | Risk Management Options and it’s Analysis | ||||
| 4 | Partculars | Options | |||
| 5 | Retention | Full Insurance | Safety Program & Retention | Safety Program & Full Insurance | |
| 6 | Option-1 | Option-2 | Option-3 | Option-4 | |
| 7 | Building Worth | $ 300,000 | $ 300,000 | $ 300,000 | $ 300,000 |
| 8 | Probability of Risk of Fire | 3% | 3% | 2% | 2% |
| 9 | Risk of Fire based on probability | $ 9,000 | $ 9,000 | $ 6,000 | $ 6,000 |
| 10 | If there is no fire:(event-a) | ||||
| 11 | Premium Cost | $ - | $ 10,000 | $ - | $ 8,000 |
| 12 | Cost of Safety Program | $ - | $ - | $ 1,500 | $ 1,500 |
| 13 | Federal Govt Fine if full insurance is not taken | $ 1,000 | $ - | $ 1,000 | $ - |
| 14 | Total Cost if fire is not occoured | $ 1,000 | $ 10,000 | $ 2,500 | $ 9,500 |
| 15 | |||||
| 16 | If there is a fire:(total loss)-(event-b) | ||||
| 17 | Risk of Fire | $ 300,000 | $ - | $ 300,000 | $ - |
| 18 | Premium Cost | $ - | $ 10,000 | $ - | $ 8,000 |
| 19 | Cost of Safety Program | $ - | $ - | $ 1,500 | $ 1,500 |
| 20 | Federal Govt Fine if full insurance is not taken | $ 1,000 | $ - | $ 1,000 | $ - |
| 21 | Total Cost if fire is not occoured | $ 301,000 | $ 10,000 | $ 302,500 | $ 9,500 |
| 22 | |||||
| 23 | If there is a fire:(based on probability of risk):(event-c) | ||||
| 24 | Risk of Fire | $ 9,000 | $ 9,000 | $ 6,000 | $ 6,000 |
| 25 | Premium Cost | $ - | $ 10,000 | $ - | $ 8,000 |
| 26 | Cost of Safety Program | $ - | $ - | $ 1,500 | $ 1,500 |
| 27 | Federal Govt Fine if full insurance is not taken | $ 1,000 | $ - | $ 1,000 | $ - |
| 28 | Total Cost if fire is not occoured | $ 10,000 | $ 1,000 | $ 8,500 | $ 3,500 |
| 29 | In all the above options the last option having safety program and full insurance is better because in the above scenarios, the option is least costly in the events a & b and in the event of c, the cost is $3500, though the cost is a little bit high compared to second option, there is a mention about the risk that though the probability reduces but total loss shall be on full. Hence option 4 is better. | ||||
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