Risk Management homework Academic Essay

Risk Management homework

1. Kruger Industries owns a small office building worth $400,000. Art Vandelay is
the risk manager. Kruger faces the risk of fire which would completely destroy
their building. The probability of a fire is known to be 3%. Kruger has a marginal
tax rate of 40%.
Kruger is considering the following risk management options to address the risk
of fire to their building:
1. Retention
2. Full Insurance for a premium of $12,500
3. Safety Program + Retention
4. Safety Program + Full Insurance [premium falls to $9,500]
The cost of the Safety Program is $2,000. It has the impact of lowering the
probability of a fire from 3% to 2%. However, if a fire does occur it is still a total
loss.
a) Construct an after-tax loss matrix. (4 points)
b) What is the actuarially fair premium [AFP] in this case (hint: AFP = P*)?
(1 point)
c) What is the AFP when safety is introduced? (2 points)
Assume Art’s worry value for retention (WVR) is $3,500 and for retention and
safety (WVRS) is $2,000.
d) If Art decides to minimize TOTAL COST, what risk management option
does he choose? Make sure that you show all calculations and clearly
define TOTAL COST in each case. (4 points)
e) What is Art’s PMAX for full insurance? (2 points)
f) During a meeting, the Chief Risk Officer (CRO) told Art that the most
he would pay for full insurance is $9,400. What is the CRO’s WVR? (2
points)
g) Who is more risk averse, the CRO or Art? Explain. (2 points)
2. Kramerica Industries has a small plant

worth $100,000. The plant is subject to
physical damages and total destruction as a result of fire. Firm has 30% tax rate.
Probability Distribution as follows:
Loss Amt ($) Probability of Loss
0 .5
1,000 .4
7,000 .06
10,000 .03
100,000 ?
Kramerica is considering the following risk management options:
1. Retention
2. Partial insurance – Face Amount = $8,000; Premium = $700
3. Deductible insurance – Face Amount = $100,000; Deductible per occurrence
= $1000; Premium = $2,000
4. Full insurance – Face Amount = $100,000; Premium = $6,000
a) Construct the after-tax loss matrix. (5 points)
b) Assume that the firm decides to choose a risk management alternative
without including valuation for subjective risk. What risk management
option is chosen? Show all work and calculations? (4 points)
The firm would like to add worry value to their analysis. For the following
questions, when using worry values, use the following abbreviations. WVR
(retention); WVP (partial insurance); WVD (deductible insurance); WVF (full
insurance).
c) What worry value(s) would make full insurance preferred to partial
insurance? Show all work and calculations and explain your numerical
answer. (2 points)
d) What worry value(s) would make deductible insurance preferred to partial
insurance? Show all work and calculations and explain your numerical
answer. (2 points)