John Smith, owner of Smith Riverside Diner, is trying to decide whether to purch

Question

John Smith, owner of Smith Riverside Diner, is trying to decide whether to purchase an insurance policy to cover flood damage on his diner that is located on the bank of Mohawk river. Rainstorms occur frequently and then Mohawk river may flood the restaurant. John estimates the potential damage from flood in the coming year as:

John is considering three alternatives for dealing with this flood risk:

• John can buy an insurance policy for $16,000 that would cover 100% of any damage losses that occur.

• John can buy an insurance policy for $8,000 that would cover all damage losses in excess of $28,000.

• John can choose to self-insure, in which case he will not have to pay any insurance premium but will pay for any losses that occur.

Part a): Construct a payoff table for this problem

Part b): What decision should be made according to the Conservative Approach?

Part c): What decision should be made according to the Minimax Regret Approach? Show the Regret table to support your answer.

Part d): What decision should be made according to the Expected Value Approach?

Part e): What is the highest amount of money that John should be willing to pay for perfect information/forecast for his flood damage?

Flood Damage No Damage Mild Damage Severe Damage Total Damage Damage Amount in Dollars $0 $15,000 $35,000 $50,000 Probability 0.62 0.22 0.11 0.05

Explanation / Answer

A) Do this part yourself

b) According to conservative approach, John should choose the $8,000 insurance policy. This will cover losses at and over $28,000. If he goes with probability, chances are less that such a situation will arise.

c) According to minimax regret approach, John should buy the $16,000 policy since the goal of this approach is to minimise regrets.

d)

EV= 0+3300+3850+2500= $9,650

Since there is 38% probability of any type of damage happening and the EV of losses sums up to $9,650, John should choose to buy the $8,000 policy.

e) More information is required for this part.

Flood damage No Mild Severe Total Damage amount ($) 0 15,000 35,000 50,000 Probability 0.62 0.22 0.11 0.05 EV 0 3300 3850 2500

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