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Burger Prince Restaurant is considering the purchase of a $100,000 fire insurance policy. The fire statistics indicate that in a given year, the probability of property damage varies across different damage amounts as follows: a $100,000 damage has a probability of 0.006, a $75,000 damage has a probability of 0.002, a $50,000 damage has a probability of 0.004, a $25,000 damage has a probability of 0.003, a $10,000 damage has a probability of 0.005, and no damage ($0) has a probability of 0.980. The requested analysis involves two parts: first, determining how much risk-neutral Burger Prince would be willing to pay for fire insurance; second, estimating the maximum amount they would be willing to pay given their utility values for different loss amounts.

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The decision-making process of Burger Prince Restaurant regarding fire insurance involves assessing their willingness to pay in two different scenarios: under risk neutrality and given their utility preferences. To systematically analyze this, it is essential to examine the expected monetary value (EMV) under risk neutrality and incorporate the utility considerations for a subjective valuation of potential losses.

Risk-Neutral Willingness to Pay

Under risk neutrality, decision-makers are solely concerned with expected monetary outcomes, ignoring risk preferences. In this context, Burger Prince’s maximum willingness to pay for fire insurance is equivalent to the expected reduction in potential losses attributable to the policy. To compute this, we first determine the expected damage cost without insurance, which involves multiplying each damage amount by its corresponding probability and summing these products:

  • $100,000 damage: 0.006 × $100,000 = $600
  • $75,000 damage: 0.002 × $75,000 = $150
  • $50,000 damage: 0.004 × $50,000 = $200
  • $25,000 damage: 0.003 × $25,000 = $75
  • $10,000 damage: 0.005 × $10,000 = $50
  • No damage: 0.980 × $0 = $0

Adding these expected damages yields the total expected annual loss:

Expected loss = $600 + $150 + $200 + $75 + $50 + $0 = $1,075

Given that the insurance policy costs $100,000, and the expected damage is only $1,075, intuitively, this value appears inconsistent as the insurance premium exceeds the expected damage, indicating over-insurance or an error in the problem statement. However, assuming the intent is to find how much they would be willing to pay to eliminate the risk, and considering the insurance fully covers the damages, the maximum risk-neutral amount would be close to the expected loss value. Since the expected damage (expected monetary benefit of insurance coverage) is $1,075, this value represents the maximum amount they would be willing to pay if they were purely risk-neutral and riskless—thus, unlikely in real terms, but useful as an analytical baseline.

Incorporating Utility Values

The second part involves assessing the decision based on utility rather than monetary value. Utility functions capture individual preferences, risk tolerance, and attitudes towards losses. The utility values assigned to different loss amounts influence the willingness to pay for insurance. Typically, as losses increase, utility decreases, often in a nonlinear fashion reflecting diminishing marginal utility of wealth.

Suppose the utility values are provided in a table, but since they are not explicitly specified in the problem statement, we model a typical concave utility function reflecting risk aversion. For example, assume utility values are:

  • Amount of $100,000: Utility = 0.2
  • Amount of $75,000: Utility = 0.4
  • Amount of $50,000: Utility = 0.6
  • Amount of $25,000: Utility = 0.8
  • Amount of $10,000: Utility = 0.9
  • Amount of $5,000: Utility = 0.95
  • $0 Loss: Utility = 1.0

Given these, the expected utility without insurance is calculated by multiplying each utility by its probability:

  • $100,000 damage: 0.006 × 0.2 = 0.0012
  • $75,000 damage: 0.002 × 0.4 = 0.0008
  • $50,000 damage: 0.004 × 0.6 = 0.0024
  • $25,000 damage: 0.003 × 0.8 = 0.0024
  • $10,000 damage: 0.005 × 0.9 = 0.0045
  • No damage: 0.980 × 1.0 = 0.98

Summing these gives the total expected utility:

Expected utility = 0.0012 + 0.0008 + 0.0024 + 0.0024 + 0.0045 + 0.98 = approximately 0.9913

To determine the maximum amount Burger Prince is willing to pay for insurance, we identify the certainty equivalent (CE)—the guaranteed utility level that makes them indifferent between insuring and not insuring. The CE can be found by solving for the loss amount that yields utility equal to the expected utility:

Assuming the utility function is continuous and invertible, the CE corresponds to a certain loss level where utility equals 0.9913. Using the utility table, the utility > 0.99 for losses up to approximately $10,000. Therefore, the risk-averse Burger Prince would be willing to pay an insurance premium that guarantees them utility at or above this level. Since utility diminishes with higher losses, they would be willing to pay up to the point where expected utility equals the utility of paying a certain premium equivalent to a loss less than or equal to $10,000.

In economic terms, if they could purchase insurance coverage that guarantees utility comparable to the equivalent of losing less than $10,000, then their maximum willingness to pay would be close to the difference between the expected loss in utility terms and their baseline utility without insurance. Consequently, considering their risk aversion, this amount roughly corresponds to a premium that reduces their exposure to large losses, increasing their overall utility.

Conclusion

Based on the analysis, the risk-neutral willingness to pay for fire insurance is roughly equal to the expected monetary loss of $1,075, which indicates that, from a purely expected value standpoint, paying anything above this amount would not make sense financially. However, given the utility considerations and risk aversion, Burger Prince would likely be willing to pay a higher premium—potentially up to a level that reduces the impact of the worst-case losses, such as $10,000—though the precise figure depends on their exact utility function. This analysis underscores the importance of understanding both the objective statistical risks and subjective utility perceptions when making insurance decisions.

References

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