David Byrne Co. owns a warehouse worth $250,000. Lou Reed is the risk manager. David Byrne faces the risk of fire which would completely destroy their warehouse. The probability of a fire is known to be 6%.

David Byrne is considering the following risk management options to address the risk of fire to their warehouse:

Retention only no Safety Program

Full Insurance Premium = $16,000

Retention + Safety Program

Full Insurance + Safety Program - Premium = $11,000

The cost of the Safety Program is $4,000. It has the impact of lowering the probability of a fire from 6% to 4%. However, if a fire does occur it is still a total loss.

1. Construct the loss matrix for David Byrne. Make sure you show loss in the top row and out-of-pocket cost in the bottom row in each cell of the loss matrix. [4 points]

2. Assume Reeds worry value for retention without safety (WV_R) is $1,200 and his worry value for retention with safety (WV_RS) is $700. Calculate the total expected cost of each of the four risk management options. [4 points]

3. If Reeds decision rule is to pick the option that minimizes total expected cost, what risk management option does he choose? [1 point]