Risk

RMI 2101

SPRING 2014

Homework Assignment #2

40 points

Please note these additional guidelines for this assignment.

My preference is that this homework be TYPED. You can insert a table to create your loss matrix. If you decide not to type it, you risk me not understanding your handwriting. Also, it must then be completed on lined paper.

All matrices are to be constructed with the Risk Management Alternatives as the rows and the States of the World as the columns, as we did in class.

Show ALL of your work, in order to receive full credit for an answer.

You can indicate your after-tax numbers in the matrix by placing parentheses around them.

At the beginning of each problem, if you show how you calculated one of the after tax numbers in the matrix, you do not have to show the work for all of the after tax numbers in the problem set.

Remember that you still need to:

1. Put your name at the top of each page.

2. Staple the pages.

3. Hand in the printed copy of your homework to me at the beginning of class on March 19th for the potential to obtain full credit.

1. A firm owns a small airplane, worth $500,000, which is subject to the risk of physical damage.

Assume that:

* The probability of loss is 3%.

* When a loss occurs, it will be a total loss.

The firm is considering four risk management options to manage this risk:

[1] Purchase full insurance for the risk of physical damage/destruction to this plane for a premium of $30,000.

[2] Use retention as an alternative to full insurance.

[3] Use a loss control measure (LC) in conjunction with full insurance.

[4] Use a loss control measure (LC) in conjunction with retention.

When LC is used:

* The cost of LC is $5000

* LC reduces the probability of loss from 3% to 2%.

* The insurer reduces the insurance premium from $30,000 to $25,000.

a. Construct an after tax loss matrix. Assume that the firm’s marginal...