Chapter 11 Loss Control

Chapter 11 Loss Control I. Multiple Choice 1. A particular loss control effort will be undertaken if a. b. c. the expected frequency of losses is reduced the expected severity of losses is reduced expected losses are reduced by an amount greater than the cost of the loss control effort all of the above d. Answer: c Type: K 2. Loss Prevention activities are aimed at reducing the a. b. c. d. frequency of losses size of a loss (for if and when a loss occurs) probability of loss to zero all of the above Answer: a Type: K 3. FunFun Toys produces assorted toy rockets. It has discovered that its water pressure rockets have a tendency to tip over just before take off thereby flying parallel, and low, to the ground. FunFun has decided to quit producing this toy rocket. This is an example of a. b. c. d. loss control loss prevention loss avoidance all of the above Answer: d Type: A 4. Loss Reduction activities are aimed at reducing the a. b. c. d. frequency of losses size of a loss (for if and when a loss occurs) probability of loss to zero all of the above 166 Answer: b Type: K 5. Segregation of exposure units can reduce a. b. c. d. the expected frequency of losses the expected severity of losses both the expected frequency and expected severity of losses only those losses that result from natural disasters Answer: b Type: K 6. Insurance coverage can reduce the incentives to undertake loss control activities if insurers a. b. c. d. help pay for the loss control don’t reduce insurance premiums to reflect the effects of the loss control activities pay for losses anyway lower premiums after loss control is implemented Answer: b Type: K Use the following information to answer questions 7-10. PTM Inc. is evaluating a loss control plan. The costs and benefits are as follows; (Ignore the implications of possible reduced insurance premiums.) Loss Control Expenditures Reduction in Expected Losses Today End of Year 1 End of Years 2-5 $10,000 $4,000 0 0 $3,400 $3,400 7. Using a cost of capital of 6%, what is the present value of the loss control expenditures (rounded to the nearest dollar)? a. b. c. d. $14,000 $13,774 $12,994 $12,755 Answer: b 167 Type: A 8. Using a cost of capital of 6%, what is the present value of the reduction in expected losses (rounded to the nearest dollar)? a. b. c. d. $17,000 $15,781 $14,322 $12,994 Answer: c Type: A 9. What decision should PTM make regarding these loss control activities? a. They should not undertake the loss control activities because the present value of the cost is greater than the present value of the benefits. They should undertake the loss control activities the present value of the cost is less than the present value of the benefits. They should be indifferent because the present value of costs and benefits are equal. They need more information to make the decision b. c. d. Answer: b Type: A 10. Using a cost of capital is 8%, what decision should PTM make regarding these loss control activities? a. b. c. d. They should not undertake the loss control activities because the present value of the cost is greater than the present value of the benefits. They should undertake the loss control activities the present value of the cost is less than the present value of the benefits. They should be indifferent because the present value of costs and benefits are equal. They need more information to make the decision Answer: a Type: A 11. Which one of the following is not a potential benefit of loss control efforts to improve workplace safety? a. b. c. d. reduced expected losses increased worker productivity improved marginal cost of safety reduced insurance premiums 168 Answer: c Type: K 12. Valuation of human life in loss control decisions is a. b. c. d. never done because it is unethical cannot be done because the computations are too complex done implicitly and by approximation using loss control dollars spent and expected lives saved not allowed by regulation Answer: c Type: K 13. Billy Bob earns $45,000 and faces a .007 probability of dying in a workplace accident. Jim Bob earns $41,000 and faces a .0038 probability of dying in a workplace accident. The two require the same level of skill and training. From this information, what is the implicit value of a person’s life? a. b. c. d. $1,250,000 $1,052,631 $571,428 $315,000 Answer: a Type: A Use this data on loss control expenditures to answer questions 14 and 15. Loss Control Expenditures $0 $80,000 $160,000 $240,000 $320,000 $400,000 Number of Worker Injuries 280 238 207 182 170 165 Average Injury Severity $6,500 14. What is the marginal benefit of increasing loss control expenditures from $80,000 to $160,000? a. b. c. d. $1,547,000 $1,345,500 $273,000 $201,500 169 Answer: d Type: A 15. What is the economically efficient level of loss control spending? a. b. c. d. $160,000 $240,000 $320,000 $400,000 Answer: b Type: A II. Fill-ins 1. Loss control refers to efforts that reduce ___expected losses___ . 2. Loss prevention activities attempt to reduce the ___expected frequency___ of losses. 3. Loss reduction activities attempt to reduce the ___size of a loss__ should one occur. 4. The installation of a sprinkler system is an example of ___pre-loss (loss reduction) activity___. 5. ___Segregation ___ of exposure units is an example of risk diversification that will reduce the expected severity of losses. 6. The value of a human life can be computed ___implicitly___ from assorted decisions made by individuals and other organization. III. Problems and Short Answer Questions 1. Describe the similarities between ‘segregation of exposures units’ and risk pooling. Answer: Both of these activities are a form of risk diversification. Both methods will typically not reduce expected losses, but will reduce the expected severity of losses by lowering the probability of very large losses. Segregation of exposure units will divide what might otherwise be a very large loss exposure into several smaller exposures. Type: K 170 2. BigTime manufacturing has substantial warehousing needs for raw materials. It currently faces the choice of building a single $12 million facility or three separate $4 million facilities. Each facility faces the following loss distribution. (The separate facilities are statistically independent.) Probability of Loss .03 .02 .95 Percent of Value Lost 100 50 0 a) What is the expected loss for each warehousing choice? b) What is the probability of a $12 million loss for warehousing choice? c) Having the three separate facilities will reduce the expected severity of losses. What are some disadvantages to this segregation of loss exposures? Answer: a) Expected loss for the $12 million facility is (.03)$12,000,000+(.02)$6,000,000+(.95)0 = $480,000 Expected loss for each of the $4 million facilities is (.03)$4,000,000+(.02)$2,000,000+(.95)0 = $160,000 Since $4 million facilities are independent, their total expected loss is (3)$160,000 = $480,000 b) The probability of a $12 million loss for the $12 million facility is .03. Whereas the probability of a $12 million loss for the three segregated facilities is (.03)(.03)(.03) = .00003. c) Some disadvantages to having the three separate facilities might be duplication of labor efforts, increased transportation cost of moving supplies and materials, decreased effectiveness of communication, etc. Type: A 3. What effect can insurance have on loss control activities? Answer: Insurance, by itself, can reduce the incentive to undertake loss control efforts. If the risk is effectively transferred to an insurer, the business firm will think it has little to gain with loss control. This moral hazard aspect of insurance can be mitigated if the insurer reduces the business firm’s insurance premium to reflect the improved loss probabilities. Type: K 171 4. Using the following data determine what level of loss control spending should be undertaken? Loss Control Expenditures $0 $50,000 $100,000 $150,000 $200,000 $250,000 Answer: Loss Control Expenditures $0 $50,000 $100,000 $150,000 $200,000 $250,000 Number of Worker Injuries 200 170 148 130 122 118 Number of Worker Injuries 200 170 148 130 122 118 Average Injury Severity $8,000 Total Cost of Injuries $1,600,000 $1,360,000 $1,184,000 $1,040,000 $976,000 $944,000 Marginal Benefit Marginal Cost $240,000 $176,000 $144,000 $64,000 $32,000 $50,000 $50,000 $50,000 $50,000 $50,000 The economically efficient level of loss control spending is $200,000. The next marginal increase of $50,000 only brings $32,000 in benefits. Type: A 5. Most people probably agree that it is very difficult to place a dollar value on human life. Explain what it means to implicitly place a dollar value on human life in ordinary decisions. Answer: Everyday decisions can affect the probabilities of death. Examples of such decisions are an individual’s choice of automobile, some employers’ decision regarding safety equipment, and governmental regulations regarding safety standards. The implicit valuation of human life is found by comparing the amount of money that one spends to reduce the probability of a death. For instance, spending $50,000 to reduce the probability of a death by the increment of .005 implies a value of life equal to ($50,000)/(.005) = $10,000,000. Type: A 172