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?

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

Part a) Payoff table is as follows

Part b) According to conservative approach, we identify the minimum payoff of each alternative. And then select the alternative whose minimum payoff is the maximum of all alternatives' minimum payoffs

Minimum payoff of alternative 1 = -16,000 (most negative)

Minimum payoff of alternative 2 = -23,000 (most negative)

Minimum payoff of alternative 3 = -50,000 (most negative)

Out of the above, maximum (least negative) is -16,000

Therefore, according to conservative approach, Alternative 1 should be chosen.

Flood Damage No Damage Mild Damage Severe Damage Total Damage Probability 0.62 0.22 0.11 0.05 Alternative 1 -16000 -16000 -16000 -16000 Alternative 2 -8000 -23000 -8000 -8000 Alternative 3 0 -15000 -35000 -50000

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