Decision Tree — Buy Flood Cover? (Risk Tolerance)
Why firms insure against negative expected value: going uninsured has the best expected outcome (−$35.4k) but, with a risk tolerance of $250k, a certainty equivalent of −$186.8k, so the risk-averse choice is the high-excess policy (CE −$40.4k) — the switch the tree states outright. Illustrative values.
Make it your own.
title "Should a 40-person manufacturer buy flood cover?"
subtitle "Net 12-month outcome of the flood risk, US$ thousands — premiums plus uninsured losses"
currency $
unit k
risk-tolerance 250
risk-profile compare
note "Risk tolerance is about a sixth of equity, a common rule of thumb for a small firm; flood bands are the site's 1-in-33-year (major) and 1-in-14-year (minor) events."
note "Illustrative values for a fictional firm."
decision "Flood cover"
"No cover" -> chance "Flooding in the next 12 months"
"Major flood" p 0.03 -> -900
"Minor flood" p 0.07 -> -120
"No flood" p rest -> 0
"Standard policy, $50k excess" cost 38 -> chance "Flooding in the next 12 months"
"Major flood" p 0.03 -> -50
"Minor flood" p 0.07 -> -50
"No flood" p rest -> 0
"High-excess policy, $150k excess" cost 24 -> chance "Flooding in the next 12 months"
"Major flood" p 0.03 -> -150
"Minor flood" p 0.07 -> -120
"No flood" p rest -> 0