Spartan utilities distributes natural gas to households in South-West Michigan. Spartan has 25,000 miles of retail gas distribution pipelines. The distribution pipelines sometimes develop leaks due to weather conditions and corrosion. Spartan estimates that the probability of a gas pipeline developing a leak is 0.0002/year/mile of pipeline. Spartan also estimates that an average leaking pipe incident results in $10,000 in repair costs, $5,000 in natural gas lost, $8,000 in compensation to affected parties, $2,000 in other costs such as evacuation, fire safety, public notification etc. Further, the disruption in service results in loss of sales of $20,000 on which Spartan would have earned profits of $4000.

a. Estimate the expected annual cost to Spartan of such leakage.

b. Suppose an insurance company offer to cover all costs of such leaks except lost sales/profits. The premium is $130,000. Should Spartan utilities buy the insurance?

c. What other risk management options can Spartan consider in managing this risk?