Risk management question?

Question

Today, my teacher gives an example that I can't understand:

a production firm has X units. Total value of them=$1,000,000. Probability of being destroyed of each unit=0.1%

That firm has 2 choices:

[A]: Buy an insurance for each unit. Total insurance fee for them=$6,000

[B]: Do nothing

=>the expected value of benefit=1,000,000*0.1%=1000 < total insurance fee

but that firm is willing to pay for insurance??? [I doubt that this is because that firm hates risk. But I don't like this explanation because it is vague, it just bases on the managers' feeling instead of scientific functions/theories)

=> Is there any explanation bases on scientific functions?

The most knotty question is:

There is a certain number of units (let's call it Y) that if X>Y, that firm will not pay for insurance. My teacher calculated Y as follow:

That firm will not pay if

6000X≥1000000

=>Y=1000000/6000=167

That calculation bases on which basis?

P.s: My teacher is not willing to explain

Answer 1

It honestly sounds to me like your teacher may not have a sufficient grasp on the topic (or the language in which) he or she is trying to explain.  At 0.1% risk (which is impossibly small, by the way) only paranoid or EXTREMELY large companies would ever bother with insurance, and even then it would need  to make financial sense.

You don&#039;t insure a $5 product if it will take you $10 to do it.  Unless you&#039;re having trouble with the Mafia, or you&#039;re trying to steal from the company.

Alternatively, if the teacher meant to say the Probability of destruction is 0.1 (or 10%), suddenly, the first part looks a lot more reasonable.

The second formula is calculating the maximum acceptable Cost Per Unit, and is based off of your original problem.  Personally, I think your teacher&#039;s math is a little...uhm... more theoretical than practical, as the formula suggests that the cost of insuraning the original product can equal the cost of new production, and most companies I&#039;ve seen don&#039;t cut the line quite that fine unless they&#039;re looking other factors.

So, I think your teacher&#039;s math comes from this:

If

(Cost of Insurance) * (number of Units)

Is Greater than or Equal to

(Cost of making the products all over again)

THEN

y= the maximum price the company is willing to pay per unit to insure.

...if that&#039;s not what the teacher was trying to say, teacher is failing to explain things to you properly, and you may wish to look into a tutor.  Actually, the math is a little spotty, if you actually want to learn the subject, you may want to get a tutor anyway...

Answer 2

Your teacher is an idiot.  

At .1% risk, NO business would buy insurance.

Answer 3

hi,

there is no quantify answer to your question. the risk management only will identify the 0.1% probability.

the concern is if the probability have suck in internal and external factor.

if according to the case. the risk is so small that it is not significant to have insurance premium of 6000.(which is d**n expensive anyway!!!)

but then in the real world, a risk is still a risk for what ever u call it. To eliminate the probability is only by taking insurance.   and in the real world it wouldn&#039;t be that expensive or no one will want the insurance&#039;s provider policy.

hope i&#039;m answering your answer.