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IE Departmental Project

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.

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 Jessica Lau Page 2 of 8

IE Departmental Project

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.

Amount of damage (d) Probability of an accident with specified range of damage

d ≤ $500 (0.3)(0.45) = 0.135

$500 < d ≤ $1000 (0.3)(0.15) = 0.045

$1000 < d ≤ $3300 (0.3)(0.25) = 0.075

$3300 < d ≤ $6600 (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 Jessica Lau Page 3 of 8

IE Departmental Project

Outcome Total cost (C)

No accident, d = $0 $1250 premium + $0 accident damage = $1250

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 $1250 premium + $500 accident damage = $1750

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.

Outcome Total cost (C)

No accident, d = $0 $0

Accident with d ≤ $500 $500

Accident with $500 < d ≤ $1000 $1000

Accident with $1000 < d ≤ $3300 $3300

Accident with $3300 < d ≤ $6600 $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 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

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 Jessica Lau Page 4 of 8

IE Departmental Project

Payoff ($)

No accident, d ≤ $500 $500 < d ≤ $1000 < d ≤ $3300 < d ≤ EMV

d = $0 $1000 $3300 $6600

With -1250 -1750 -1750 -1750 -1750 -1400

insurance

Without 0 -500 -1000 -3300 -6600 -657

insurance

Probability 0.7 0.135 0.045 0.075 0.045

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 Jessica Lau Page 5 of 8

IE Departmental Project

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 Jessica Lau Page 6 of 8

IE Departmental Project

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.

22 November 2010 CES H102-029 Jessica Lau Page 7 of 8

IE Departmental Project

22 November 2010 CES H102-029 Jessica Lau Page 8 of 8

IE Departmental Project

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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