I need help with these practice problems first 3 page has the answers to answers to part 2 practice problems you need to answer the rest. Part 2 start on page 4. Thank you
RMI 2101 Practice Problem Chapter 7 Part 2 CASE 1: Choosing Risk Management Options for an Office Building PART 1 ANSWERS Assume a firm owns a small office building worth $300,000. To manage the risk of property loss, the firm can purchase full insurance for the risk of physical damage/destruction for a premium of $10,000. The firm is also considering retention as an alternative to full insurance. Assume that the probability of property loss is known to be 3%. Assume that if a loss occurs, it will be a total loss. Assume that the firm's marginal tax rate is 40%. 1. Construct an after tax loss matrix. (1 point - entire matrix must be correct to receive credit) Loss (.3) No Loss(.97) Full Insurance 10,000 10,000 10,000(1-.40)=(6,000) 10,000(1-.40)=(6,000) Retention 300,000 0 300,000(1-.40)=(180,000) (0) 2. Using the cell that represents the intersection of \"no loss\" and the \"purchase of full insurance\". (1 point - both a. and b. must be correct to receive credit) a. Describe what the pre-tax number in that cell means. If you have no loss and you are insured $10000 is the pretax cost of the tax deductable expenditure. b. Describe what the after-tax number in that cell means. If you have no loss and you are ensured $6000 is the after tax cost of this tax deductible expenditure. 3. Suppose the risk manager wants to minimize expected costs (EC) as her decision rule. (1 point - both a. and b. must be correct to receive credit) a. Estimate the EC (expected costs or expected expenses) for each risk management alternative. Show all EC calculations and work. Retention the Expected Cost: (180,000)(.03)+(0)(.97)=$5,400 Full Insurance the Expected Cost: (6,000)(.03)+(6,000)(.97)=$6,000 b. What risk management alternative does she choose. Explain. Choose Retention 4. The firm is not considering self-insurance because the risk manager fears a loss that has too high an expected cost or that might be unpredictable. (1 point - a., b., and c. must be correct to receive credit) a. If a catastrophic loss occurs, which risk financing goal could this violate? Explain. (1 point) Pay for losses, maintain appropriate liquidity level, manage uncertainty. b. What type of risk financing transfer option could the risk manager use to manage this disadvantage of self-insurance? Explain. (1 point) Excess insurance or stop loss insurance. 1 RMI 2101 Practice Problem Chapter 7 Part 2 c. What cost of risk has to be considered to make the decision discussed in part b? (1 point) Premium 5. Actuarially fair premium. Estimate the after-tax actuarially fair premium and explain what this means. (1 point) $5,400 6. Define and describe the intangible cost we will use to measure the subjective risk associated with making the risk management alternative decision. (1 point) Worry Value Now assume that the firm is trying to decide whether or not to use a safety training program (call this SP) in conjunction with retention and full insurance. The cost of the safety program is $1,500. From past data, the firm knows that if the SP is used with these risk management options it will reduce the peril probability from 3% to 2%. The insurer agrees to reduce the insurance premium from $10,000 to $8,000 if the loss control measure is used. Assume that the Worry Value for retention falls to $2000 if the SP is used in conjunction with these risk management options. Note that there are now four risk management options/alternatives under consideration. 1. What type of loss control option is the SP and what risk control goal does it meet? Explain using the case materials. (1 point) Prevention & frequency decrease probability. 2. Four Risk Management Options (Hint: two include retention and two include insurance.) List the four risk management options. For each risk management option, explain what type of risk financing it is and whether or not it is combined with any risk control. (1 point) Retention Retention with safety program Full Insurance Full Insurance safety program 3. Design the probability distributions a. When the SP is NOT used. What is the random variable in this distribution? (1 point) When the SP is NOT used: No Safety Program Probability Loss 0.03 No Loss 0.97 2 RMI 2101 Practice Problem Chapter 7 Part 2 Safety Program Probability Loss 0.2 No Loss 0.98 b. When the SP is used. Explain why this distribution is different from the one you designed in part a. (1 point) When we use the SP the distribution is different due to the change in the probability which is lower and avoid the loss of the building by purchasing the SP with lower probability. 3 RMI 2101 Practice Problem Chapter 7 Part 2 CASE 1 Choosing Risk Management Options for an Office Building. The case information is reprinted here but you will need you analyses from Part 1 to complete the following questions. Assume a firm owns a small office building worth $300,000. To manage the risk of property loss, the firm can purchase full insurance for the risk of physical damage/destruction for a premium of $10,000. The firm is also considering retention as an alternative to full insurance. Assume that the probability of property loss is known to be 3%. Assume that if a loss occurs, it will be a total loss. In question 3 of Chapter 7 Part 1 problem, the risk manager decided to make decisions based on expected costs alone. However, the Chief Risk Officer (CRO) is unhappy with the decision to choose retention. The CRO keeps asking the risk manager what will happen if, in the future, the company suffers a catastrophic loss. Finally, having been plagued by the uncertainty related to the risk manager's decision, the CRO has decided that he wants to include both tangible and intangible costs when selecting the risk management alternative. Assume that the CRO has a worry value for retention (WV R) equal to $3,500. 1. Which risk management goal/objective did the RM fail to meet when she selected retention? Explain and note if this is a pre or post loss goal/objective. (Note, this question is not about risk financing objectives.) 2. Define the CRO's new decision rule. 3. Using the new decision rule, what risk management alternative does the organization now choose. Show all expected cost and total cost estimations and work and explain why management is less uneasy with this option. Despite the choice driven by the CRO's worry value, during a meeting, the risk manager tells the Chief Executive Officer (CEO) and the CRO that the most she would pay for insurance for this is loss is $6,400. 4. What is the risk manager's worry value? 5. What is the CRO's PMAX? 6. Who is more risk averse, the CRO or the risk manager? Explain. 4 RMI 2101 Practice Problem Chapter 7 Part 2 Now assume that the firm is trying to decide whether or not to use a safety training program (call this SP) in conjunction with retention and full insurance. The cost of the safety program is $1,500. From past data, the firm knows that if the SP used with these risk management options it will reduce the peril probability from 3% to 2%. The insurer agrees to reduce the insurance premium from $10,000 to $8,000 if the loss control measure is used. Assume that the CRO's worry value for retention (WVR) falls from $3,500 to $2,000 if the SP is used in conjunction with this risk management option. Note that there are now four risk management options/alternatives under consideration. 7. Construct a complete, after-tax loss matrix for these states of the world and four risk management alternatives. 8. Per the CRO's previous decision, the risk manager will make her decision based on the total cost for each risk management option. What risk management alternative does she choose for the organization? Show all total cost calculations and work and explain why the risk manager selects the option. 5 RMI 2101 Practice Problem Chapter 7 Part 2 CASE 2 Physical Plant Fires, Partial Losses and Worry Values Kramerica Industries has a small plant worth $80,000. The plant is subject to physical damages and total destruction as a result of fire. The firm has a 30% tax rate. From over 10,000 industry observations, the firm has derived the following probability distribution of fire losses for its physical plant. Loss is dollars ($) Probability of the loss 0 .5 40,000 .2 60,000 .1 80,000 ? Kramerica is considering the following 4 risk management options: Retention Partial insurance Policy Face Amount = $75,000 Premium = $2,000 Deductible insurance Policy Face Amount = of $80,000 Deductible per occurrence = $2,000 Premium = $3,000 Full insurance Policy Face Amount = $80,000 Premium = $10,000. 1. Construct the after tax loss matrix. 2. Using the cell that represents the use of partial insurance when the state of the world is a total loss, describe what the after-tax value in that cell means. 3. Assume that the firms decides to choose a risk management alternative without including valuation for subjective risk. Calculate the expected loss (cost) for each risk management alternative and choose the alternative that minimizes expected loss (cost). Show all work and calculations? 6 RMI 2101 Practice Problem Chapter 7 Part 2 The firm would like to add worry value to their analysis. For the following questions, when using worry values, use the following abbreviations. WV R (retention); WVP (partial insurance); WVD (deductible insurance); WVF (full insurance). 4. What worry value would make full insurance preferred to partial insurance? Show all work and calculations and explain your numerical answer. 5. Explain the reason for the value of WVF in question 4. 6. What should you do next to decide whether to use partial or full insurance? 7. What worry value would make deductible insurance preferred to partial insurance? Show all work and calculations and explain your numerical answer. Suppose now that Kramerica must undergo a physical inspection before it can purchase insurance. The inspection reports shows that the plant has highly flammable insulation. Kamerica did not know this information before, did not use data for firms that had this type of insulation to estimate the probability distribution and cannot change the insolation before it purchase insurance. 8. Explain how this hazard affects the loss frequency and severity. 9. Explain how the worry values for the risk management options will change for the firm. Question 3 When purchasing health insurance, name a factor that would increase a person's worry value and thus the PMAX. Explain. (1 point) 7 RMI 2101 Practice Problem Chapter 7 Part 2 CASE 1: Choosing Risk Management Options for an Office Building PART 1 ANSWERS Assume a firm owns a small office building worth $300,000. To manage the risk of property loss, the firm can purchase full insurance for the risk of physical damage/destruction for a premium of $10,000. The firm is also considering retention as an alternative to full insurance. Assume that the probability of property loss is known to be 3%. Assume that if a loss occurs, it will be a total loss. Assume that the firm's marginal tax rate is 40%. 1. Construct an after tax loss matrix. (1 point - entire matrix must be correct to receive credit) Loss (.3) No Loss(.97) Full Insurance 10,000 10,000 10,000(1-.40)=(6,000) 10,000(1-.40)=(6,000) Retention 300,000 0 300,000(1-.40)=(180,000) (0) 2. Using the cell that represents the intersection of \"no loss\" and the \"purchase of full insurance\". (1 point - both a. and b. must be correct to receive credit) a. Describe what the pre-tax number in that cell means. If you have no loss and you are insured $10000 is the pretax cost of the tax deductable expenditure. b. Describe what the after-tax number in that cell means. If you have no loss and you are ensured $6000 is the after tax cost of this tax deductible expenditure. 3. Suppose the risk manager wants to minimize expected costs (EC) as her decision rule. (1 point - both a. and b. must be correct to receive credit) a. Estimate the EC (expected costs or expected expenses) for each risk management alternative. Show all EC calculations and work. Retention the Expected Cost: (180,000)(.03)+(0)(.97)=$5,400 Full Insurance the Expected Cost: (6,000)(.03)+(6,000)(.97)=$6,000 b. What risk management alternative does she choose. Explain. Choose Retention 4. The firm is not considering self-insurance because the risk manager fears a loss that has too high an expected cost or that might be unpredictable. (1 point - a., b., and c. must be correct to receive credit) a. If a catastrophic loss occurs, which risk financing goal could this violate? Explain. (1 point) Pay for losses, maintain appropriate liquidity level, manage uncertainty. b. What type of risk financing transfer option could the risk manager use to manage this disadvantage of self-insurance? Explain. (1 point) Excess insurance or stop loss insurance. 1 RMI 2101 Practice Problem Chapter 7 Part 2 c. What cost of risk has to be considered to make the decision discussed in part b? (1 point) Premium 5. Actuarially fair premium. Estimate the after-tax actuarially fair premium and explain what this means. (1 point) $5,400 6. Define and describe the intangible cost we will use to measure the subjective risk associated with making the risk management alternative decision. (1 point) Worry Value Now assume that the firm is trying to decide whether or not to use a safety training program (call this SP) in conjunction with retention and full insurance. The cost of the safety program is $1,500. From past data, the firm knows that if the SP is used with these risk management options it will reduce the peril probability from 3% to 2%. The insurer agrees to reduce the insurance premium from $10,000 to $8,000 if the loss control measure is used. Assume that the Worry Value for retention falls to $2000 if the SP is used in conjunction with these risk management options. Note that there are now four risk management options/alternatives under consideration. 1. What type of loss control option is the SP and what risk control goal does it meet? Explain using the case materials. (1 point) Prevention & frequency decrease probability. 2. Four Risk Management Options (Hint: two include retention and two include insurance.) List the four risk management options. For each risk management option, explain what type of risk financing it is and whether or not it is combined with any risk control. (1 point) Retention Retention with safety program Full Insurance Full Insurance safety program 3. Design the probability distributions a. When the SP is NOT used. What is the random variable in this distribution? (1 point) When the SP is NOT used: No Safety Program Probability Loss 0.03 No Loss 0.97 2 RMI 2101 Practice Problem Chapter 7 Part 2 Safety Program Probability Loss 0.2 No Loss 0.98 b. When the SP is used. Explain why this distribution is different from the one you designed in part a. (1 point) When we use the SP the distribution is different due to the change in the probability which is lower and avoid the loss of the building by purchasing the SP with lower probability. 3 RMI 2101 Practice Problem Chapter 7 Part 2 CASE 1 Choosing Risk Management Options for an Office Building. The case information is reprinted here but you will need you analyses from Part 1 to complete the following questions. Assume a firm owns a small office building worth $300,000. To manage the risk of property loss, the firm can purchase full insurance for the risk of physical damage/destruction for a premium of $10,000. The firm is also considering retention as an alternative to full insurance. Assume that the probability of property loss is known to be 3%. Assume that if a loss occurs, it will be a total loss. In question 3 of Chapter 7 Part 1 problem, the risk manager decided to make decisions based on expected costs alone. However, the Chief Risk Officer (CRO) is unhappy with the decision to choose retention. The CRO keeps asking the risk manager what will happen if, in the future, the company suffers a catastrophic loss. Finally, having been plagued by the uncertainty related to the risk manager's decision, the CRO has decided that he wants to include both tangible and intangible costs when selecting the risk management alternative. Assume that the CRO has a worry value for retention (WV R) equal to $3,500. 1. Which risk management goal/objective did the RM fail to meet when she selected retention? Explain and note if this is a pre or post loss goal/objective. (Note, this question is not about risk financing objectives.) 2. Define the CRO's new decision rule. 3. Using the new decision rule, what risk management alternative does the organization now choose. Show all expected cost and total cost estimations and work and explain why management is less uneasy with this option. Despite the choice driven by the CRO's worry value, during a meeting, the risk manager tells the Chief Executive Officer (CEO) and the CRO that the most she would pay for insurance for this is loss is $6,400. 4. What is the risk manager's worry value? 5. What is the CRO's PMAX? 6. Who is more risk averse, the CRO or the risk manager? Explain. 4 RMI 2101 Practice Problem Chapter 7 Part 2 Now assume that the firm is trying to decide whether or not to use a safety training program (call this SP) in conjunction with retention and full insurance. The cost of the safety program is $1,500. From past data, the firm knows that if the SP used with these risk management options it will reduce the peril probability from 3% to 2%. The insurer agrees to reduce the insurance premium from $10,000 to $8,000 if the loss control measure is used. Assume that the CRO's worry value for retention (WVR) falls from $3,500 to $2,000 if the SP is used in conjunction with this risk management option. Note that there are now four risk management options/alternatives under consideration. 7. Construct a complete, after-tax loss matrix for these states of the world and four risk management alternatives. 8. Per the CRO's previous decision, the risk manager will make her decision based on the total cost for each risk management option. What risk management alternative does she choose for the organization? Show all total cost calculations and work and explain why the risk manager selects the option. 5 RMI 2101 Practice Problem Chapter 7 Part 2 CASE 2 Physical Plant Fires, Partial Losses and Worry Values Kramerica Industries has a small plant worth $80,000. The plant is subject to physical damages and total destruction as a result of fire. The firm has a 30% tax rate. From over 10,000 industry observations, the firm has derived the following probability distribution of fire losses for its physical plant. Loss is dollars ($) Probability of the loss 0 .5 40,000 .2 60,000 .1 80,000 ? Kramerica is considering the following 4 risk management options: Retention Partial insurance Policy Face Amount = $75,000 Premium = $2,000 Deductible insurance Policy Face Amount = of $80,000 Deductible per occurrence = $2,000 Premium = $3,000 Full insurance Policy Face Amount = $80,000 Premium = $10,000. 1. Construct the after tax loss matrix. 2. Using the cell that represents the use of partial insurance when the state of the world is a total loss, describe what the after-tax value in that cell means. 3. Assume that the firms decides to choose a risk management alternative without including valuation for subjective risk. Calculate the expected loss (cost) for each risk management alternative and choose the alternative that minimizes expected loss (cost). Show all work and calculations? 6 RMI 2101 Practice Problem Chapter 7 Part 2 The firm would like to add worry value to their analysis. For the following questions, when using worry values, use the following abbreviations. WV R (retention); WVP (partial insurance); WVD (deductible insurance); WVF (full insurance). 4. What worry value would make full insurance preferred to partial insurance? Show all work and calculations and explain your numerical answer. 5. Explain the reason for the value of WVF in question 4. 6. What should you do next to decide whether to use partial or full insurance? 7. What worry value would make deductible insurance preferred to partial insurance? Show all work and calculations and explain your numerical answer. Suppose now that Kramerica must undergo a physical inspection before it can purchase insurance. The inspection reports shows that the plant has highly flammable insulation. Kamerica did not know this information before, did not use data for firms that had this type of insulation to estimate the probability distribution and cannot change the insolation before it purchase insurance. 8. Explain how this hazard affects the loss frequency and severity. 9. Explain how the worry values for the risk management options will change for the firm. Question 3 When purchasing health insurance, name a factor that would increase a person's worry value and thus the PMAX. Explain. (1 point) 7
