CH4 Flashcards
Cost-Benefit Analysis
Each technique should be used up to the point at which each dollar spent on the measure will produce a dollar in saving through reduction in losses.
This is simply cost-benefit analysis, which attempts to measure the benefit of any course of action against its costs.
major complication in using cost-benefit analysis in risk management decisions is that
while costs are measurable, the benefits resulting from the choices may be unknown.
Where there is uncertainty about future benefits, one can estimate expected value of the benefits computed from the potential payoffs and the probabilities of various outcomes.
Expected Value
Decision theory suggests 3 decision-making situations, based on the decision-maker’s knowledge about the possible outcomes (states of nature)
Decision making under certainty: the outcomes that result from each choice are known
Decision-making under risk: the outcomes are uncertain but probability estimates are available for various outcomes.
Decision-making under uncertainty: the probability of occurrence of each outcome is not known.
Criteria for Decision-Making Under Risk
where the probability of outcomes can be reasonably predicted) expected values can indicate the most promising choice (favorable outcome).
Each decision or choice is described in terms of a payoff matrix, whose rows represent choices and whose columns represent the outcomes or states of nature.
The expected value for a particular decision is the sum of the weighted payoffs for that decision (i.e., the probability times the dollar outcome).
Problems with Expected Value Strategy for Insurance and Retention Decisions
The expected value model requires accurate information on the probabilities, which is not available as often as desired.
Even when accurate probability estimates are available, actual experience may deviate from the expected value.
The expected value criteria for retention and transfer decisions will always suggest retention as the preferred choice.
Pascal’s Wager introduces two significant principles for decision-making.
There are situations in which the consequence (magnitude of potential loss) rather than the probability should be the first consideration.
Even when dependable probability estimates are not available, decisions made under conditions of uncertainty can be made on a rational basis.
The Rules of Risk Management
Don’t Risk More Than You Can Afford to Lose
Consider the Odds
Don’t Risk a Lot for a Little
is the characteristic of the risk itself that determines which of the risk management tools is appropriate in a given situation
Minimax Regret Strategy
decision maker attempts to minimize the maximum loss or maximum regret.
Probabilities are ignored in the minimax regret strategy.
Minimax regret is an appropriate strategy when the maximum cost associated with one of the outcomes is unacceptable to management.
Common Errors in Buying Insurance
Buying too much.
- Buying too little.
- Buying too much and too little at the same time.
Priority Ranking for Insurance Coverages
Essential insures against losses that could cause bankruptcy.
Important insures against losses that would require resort to credit.
Optional insures against losses that could be met from assets or cash flow.
Large Loss Principle
The probability that a loss may or may not occur is less important than potential severity of the loss if it should occur.
Insurance as a Last Resort
Insurance always costs more than the expected value of the loss (to account for the operating costs).
People who purchase coverage against small loss exposures do so at the expense of losses that could be financially catastrophic.
Other Considerations in the Choice Between Insurance and Retention
The choice between retention and insurance is sometimes influenced by factors other than the first rule of risk management.
The cost of financing risk
Tax treatment of premiums and losses
