Loss control activities to manage risks

What does it mean to diversify by segregating assets?

It means spreading assets across different locations or units to reduce the chance that a single event (like a hurricane) destroys everything at once.

What are the two options the company has to expand?

1. Double the size of the existing plant (no segregation). 2. Build a second identical plant at a new location (segregation).

If there is no segregation, what is the value of the plant and the probability of a total loss?

Value: $100 million, Probability of total loss: 5% (0.05).

With segregation, what happens to the probabilities of outcomes (full loss, partial loss, no loss)?

Loss of $100M (both plants destroyed): 0.0025, Loss of $50M (one plant destroyed): 0.095, No loss: 0.9025.

What formulas are used to calculate the probabilities when segregating assets?

1. Both plants destroyed: 0.05×0.05=0.0025, 2. Only one plant destroyed: 2×0.05×0.95=0.095, 3. No plant destroyed: 0.95×0.95=0.9025.

Does segregation change the expected direct loss?

No. The expected direct loss remains $5 million.

How does segregation affect risk overall?

Segregation reduces the probability of very large losses and reduces the standard deviation (volatility) of losses.

What happens to indirect losses when assets are segregated?

Indirect losses (like reputational damage or business interruption) become much smaller because the chance of a full catastrophic loss decreases.

What is the expected indirect loss with and without segregation?

Without segregation: $0.5 million, With segregation: $0.025 million.

Why is reducing the probability of catastrophic events important for indirect losses?

Because catastrophic events cause not only big direct losses but also huge indirect losses like lawsuits, customer loss, and regulatory penalties.

Why do governments impose safety regulations?

To address underinvestment in prevention, to centralize research, and to correct market failures.

What are government safeguards, and why are they important?

Government safeguards are safety regulations that protect society by ensuring firms meet minimum safety standards, preventing firms from ignoring risks.

What are two downsides of government regulation?

Regulations can be costly for firms and the public; government officials may have personal or political goals that interfere with fair enforcement.

Why do loss control decisions sometimes require valuing life?

Because improving safety often reduces the probability of death, and decision-makers must compare the cost of safety improvements with the value of the lives saved.

What is the 'value of a statistical life'?

It is the monetary value placed on reducing the probability of death by a small amount, based on people's real-world behavior or willingness to pay.

What are two methods to estimate the value of a statistical life?

• Method 1: Observing wage differences between risky and safe jobs (wage differentials).

• Method 2: Asking people how much they are willing to pay for small risk reductions (survey method).

Explain how wage differentials can be used to estimate the value of life.

By comparing higher wages for riskier jobs and the difference in death probabilities, we can calculate how much workers are compensated for taking additional risk, which gives the value of a statistical life.

What is a potential problem with using surveys to estimate the value of life?

People may not answer realistically in surveys (hypothetical bias), giving numbers that don't reflect what they would actually pay or accept.

Why do governments need the value of life estimates when making safety regulations?

To decide whether the cost of implementing a safety rule is justified by the number of lives it will save.

Give an example of a government regulation where the cost per life saved is low and one where it is very high.

Low cost: FAA airplane fire protection = $300,000 per life saved. High cost: EPA asbestos ban = $78 million per life saved.

Formulas for estimating the value of life:

• Wage Premium = Change in Death Probability × Value of Life.

• Value of Life = Wage Premium / Probability of Death