You're a homeowner in San Fran, and you need to decide whether or not to purchase insurance to cover damages in the event of an earthquake. The annual cost of the earthquake insurance policy is $2,000, which will cover 95% of the cost of damages (ie, assume the homeowner must pay 5% of damages). If you decide to buy insurance, assume that you maintain coverage for all 10 years.

After consulting with a professor, you assess the probabilities of an earthquake hitting your home over the next 10 years to be as follows:

• 1% chance of a catastrophic earthquake, 10% chance of a big one, 24% chance of a moderate one, and a 65% chance of a small one.
• For simplicity, assume that 1 earthquake occurs in the next 10 years; of course, in reality, this is not true.

With a small earthquake, you expect damages of only $100 (some glasses break); with a moderate one, damages will be $3,000 (flat screen TV falls down); with a big one, damages will be $40,000 (windows shatter); and with a catastrophic one, damages are $500,000 (structural home damages).What is the optimal decision if you wish to minimize expected costs over the next 10 years?

1. Draw a decision tree for your earthquake insurance purchase decision.

2. What are the expected costs? You may ignore cost discounting.

3. What factors would you consider in addition to the lowest expected cost in deciding whether or not to purchase the earthquake insurance and why? (There is no one right answer.)