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### Chap011

Course: FINA 4354, Fall 2008
School: U. Houston
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Word Count: 614

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11 Loss Chapter Control McGrawHill/Irwin Copyright2004bytheMcGrawHillCompanies,Inc.Allrightsreserved. TypesofLossControl Loss control: Expenditures of time, money, or effort to reduce expected losses Loss Prevention reduce probability of loss Loss Reduction reduce severity of loss H&amp;N, Ch. 11 T11. HowLossControlAffectsaProbabilityDistribution How would the probability distribution for property...

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11 Loss Chapter Control McGrawHill/Irwin Copyright2004bytheMcGrawHillCompanies,Inc.Allrightsreserved. TypesofLossControl Loss control: Expenditures of time, money, or effort to reduce expected losses Loss Prevention reduce probability of loss Loss Reduction reduce severity of loss H&N, Ch. 11 T11. HowLossControlAffectsaProbabilityDistribution How would the probability distribution for property losses change if Install a sprinkler system? Replace old wiring? Discrete Distribution: Property Losses for the coming Year \$1.000 million \$0.500 million \$0.250 million \$0.100 million Probability 0.01 0.05 0.10 0.20 Continuous Distribution: Probability density Losses H&N, Ch. 11 T11. ImportanceofIndirectLosses Recall, large losses can cause indirect losses: Lost profits Clean-up costs Costs of raising capital Foregone investment opportunities Bankruptcy costs Thus, reducing probability of large losses (MPL) can reduce indirect losses Main point: need to consider reduction in expected indirect losses when making risk management decisions Diversification does not change expected direct losses, but does reduce maximum probable loss and therefore reduces expected indirect losses H&N, Ch. 11 T11. DiversificationbySegregatingAssets No segregation: 1 plant worth \$100 million, Probability of complete loss = 0.05 Expected direct loss = Segregation: 2 plants each worth \$50 million, Probability of complete loss at each plant = 0.05 Outcome at each plant are independent of the other What is the Probability distrn for total losses: Expected direct loss = H&N, Ch. 11 T11. DiversificationbySegregatingAssets Now assume an indirect loss equal to \$10 million occurs if a \$100 million direct loss occurs No segregation expected indirect loss = Segregation expected indirect loss = Main Point: diversification that reduces probability of high losses, can reduce expected indirect losses H&N, Ch. 11 T11. CostBenefitAnalysis Should compare costs and benefits of loss control Identifying costs and benefits Example: Safer work environment What are the costs? What are the benefits? H&N, Ch. 11 T11. CostBenefitAnalysisExample Example: Average Loss Severity = \$20,000. Total number of employees = 5,000 Safety Expenditure 0 500,000 1,000,000 2,000,000 1,500,000 Annual Accident Frequency per Employee 0.100 0.080 0.070 0.066 0.063 Expected Accident Costs per Employee Total Expected Accident Costs H&N, Ch. 11 T11. IncorporatingTimeDimension Often costs and benefits occur over time Need to calculate present values Example: Cost = \$1 million Benefit = reduction in liability cost of \$300,000 for each of next four years Cost of capital = 8% H&N, Ch. 11 T11. IncorporatingTimeDimension Map the expected cash flows (in \$millions) Today 4yrs -1 0.3 1 yr 0.3 2 yrs 0.3 3 yrs 0.3 0.3 0.3 0.3 0.3 NPV = + + Discount1the .future .08 2 +1.08 3 +1.08 4 1 08 1 cash flows to find net present value: H&N, Ch. 11 T11.1 IdentifyingCostsandBenefitsinPractice Benefits of loss control can be difficult to estimate Can use historical data on your own firm Use industry data Hire consultants, brokers Get estimates of insurance premium reductions Brokers and insurers H&N, Ch. 11 T11.1 GovernmentSafetyPrograms Examples: OSHA EPA CPSC Why have safety regulations? Firms may not consider all benefits of loss control if workers or customers are not fully informed Avoids duplication of expenditures on safety research H&N, Ch. 11 T11.1 ValuingLife Often loss control decisions involve changing the probability of death How do you value a life? One approach: Use wage differentials for j...

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