22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 1 of 8

Decision Analysis: Purchasing a Car Insurance Policy

Problem Jee Min, a high school student, has bought a 1998 Chevy Cavalier with a Kelly Blue Book value of $6600. He is trying to determine whether or not to buy collision insurance. Specifically, he is interested in a policy with a $500 deductible per accident and a $1250 premium for a six-month period. Should he purchase the insurance? Given information 1. According to the National Highway Safety Administration, the probability that a teenage driver will have exactly one automobile accident in a six-month period is 30%. 2. According to the National Highway Safety Administration, the probabilities of various possible amounts of damage (d) to a car caused in an accident are: a. d ≤ $500: 45% b. $500 < d ≤ $1000: 15% c. $1000 < d ≤ $3300: 25% d. $3300 < d ≤ $6600: 15% Assumptions 1. Jee Min is a typical driver for his age, and the statistic regarding the probability of having a car accident applies to him. 2. When analyzing the costs associated with potential car accidents, it is assumed that Jee Min is at fault for all of them. This means that he must pay for the damage to his car in all cases. Probability calculations for all possible outcomes Because the probability of Jee Min having a car accident within the six months is 30%, or 0.3, the probability of him not having a car accident is 1 – 0.3 = 0.7. The probabilities for all possible outcomes are shown in Diagram 1 below.

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 2 of 8

Diagram 1: Probability tree diagram for all possible outcomes

To determine the probabilities that an accident with the specified ranges of damage would occur, the probability that an accident would happen was multiplied by the probability for each range of damage. Table 1: Probability calculations Amount of damage (d) d ≤ $500 $500 < d ≤ $1000 $1000 < d ≤ $3300 $3300 < d ≤ $6600

Probability of an accident with specified range of damage (0.3)(0.45) = 0.135 (0.3)(0.15) = 0.045 (0.3)(0.25) = 0.075 (0.3)(0.15) = 0.045

Payoff analysis For each possible decision (to buy insurance or not to buy insurance), there are five possible outcomes: either no accident occurs within the six months, or an accident occurs with damage to the car in four possible monetary ranges. The amount that Jee Min has to pay is analyzed in terms of the highest damage value in each range: for example, in the $500 < d ≤ $1000 damage range, the high end value of $1000 was used in payoff calculations. With insurance, the maximum amount that Jee Min has to pay in an accident is $500, even if the damage amounts more than that (the insurance policy has a $500 deductible). The total costs (C) that Jee Min would have to pay for each outcome if he purchased insurance are shown in Table 2 below.

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 3 of 8

Table 2: Total costs with insurance for all possible outcomes Outcome Total cost (C) No accident, d = $0 $1250 premium + $0 accident damage = $1250 $1250 premium + $500 accident damage = $1750 Accident with d ≤ $500 $1250 premium + $500 accident damage = $1750 Accident with $500 < d ≤ $1000 $1250 premium + $500 accident damage = $1750 Accident with $1000 < d ≤ $3300 $1250 premium + $500 accident damage = $1750 Accident with $3300 < d ≤ $6600 If Jee Min does not have insurance, he has to pay the full amount of damage in each case. However, he does not have the added cost of the insurance premium. Total cost values without insurance are shown in Table 3. Table 3: Total costs without insurance for all possible outcomes Outcome Total cost (C) No accident, d = $0 $0 $500 Accident with d ≤ $500 $1000 Accident with $500 < d ≤ $1000 $3300 Accident with $1000 < d ≤ $3300 $6600 Accident with $3300 < d ≤ $6600

The expected monetary value (EMV) for each decision was calculated. EMV is the overall expected value, calculated based on each outcome and its probability:
EMV  (damage cost)(probability of damage cost)  C  P(C ) EMV  C1  P(C1 )  C2  P(C2 )  C3  P(C3 )  C4  P(C4 )  C5  P(C5 )

Using the probability values calculated in Table 1, the EMV for if Jee Min purchases insurance is: EMV  (damage cost)(probability of damage cost)  C  P(C )

EMV  (1250)(0.7)  (1750)(0.135)  (1750)(0.045)  ( 1750)(0.075)  (1750)(0.045) EMV  $1400
If Jee Min does not purchase insurance, the EMV is:

EMV  (damage cost)(probability of damage cost)  C  P(C ) EMV  (0)(0.7)  (500)(0.135)  (1000)(0.045)  ( 3300)(0.075)  (6600)(0.045) EMV  $657
The expected monetary values are negative, indicating that Jee Min loses, or pays, a weighted average value of $1400 with insurance and $657 without insurance. A summary of payoffs and expected monetary values is shown in Table 4 and Diagram 2 below.

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 4 of 8

Table 4: Payoff analysis for buying and not buying insurance Payoff ($) No accident, d ≤ $500 $500 < d ≤ $1000 < d ≤ d = $0 $1000 $3300 With -1250 -1750 -1750 -1750 insurance Without 0 -500 -1000 -3300 insurance Probability 0.7 0.135 0.045 0.075

$3300 < d ≤ $6600 -1750 -6600 0.045

EMV -1400 -657

Diagram 2: Decision tree with payoff values and expected monetary values

Conclusion Based on the payoff analysis, it is determined that Jee Min should not purchase the insurance policy. If he bought the insurance, he would have to pay a weighted average of $1400 compared to the $657 without insurance. Without insurance, Jee Min would have to cover the entire damage cost in an accident, but the probability of an accident is only 30%. With insurance, he

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 5 of 8

would have to pay the premium of $1250 regardless of whether he would have an accident or not. The EMV is lower if Jee Min chooses not to buy insurance because there is a 70% chance of him not having an accident and not having to pay anything, as compared to the 100% chance of paying at least $1250 with insurance. One limitation of this model is the assumption that in each accident, Jee Min would be at fault and that he would have to pay to repair the damage to his car. The probability of an accident where Jee Min would be at fault was not known. An improvement to the model would be to take this element into consideration: in the cases where damage to the car is sustained but Jee Min is not at fault, he would not have to pay for the damage.

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 6 of 8

Appendix: Calculating EMVs in Microsoft Excel The EMVs for each decision can be calculated separately, as illustrated in Figures 1 and 2 below. For each outcome, the amount of damage is multiplied by the probability of each outcome. The EMV contributions are then summed to get the total EMV. Figure 1: Calculating EMVs for with insurance

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 7 of 8

Figure 2: Calculating EMVs for without insurance

22 November 2010

CES H102-029 IE Departmental Project

Jessica Lau

Page 8 of 8

The EMVs for both decisions can also be calculated with all the data placed in a single table, specifically in the format of Table 4. This process is illustrated in Figure 3 below. The SUMPRODUCT function in Excel can be used to calculate the sum of multiple products. Two arrays are given in the argument: for example, the damage values with insurance (B3:F3) and the probabilities of each damage value ($B$5:$F$5). The probabilities are entered as constants because the same array of probabilities is used to calculate the EMVs for with and without insurance. The SUMPRODUCT function sums the products B3*B5, C3*C5, D3*D5, E3*E5, and F3*F5.

Figure 3: Calculating EMVs for both decisions, with and without insurance

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