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Chapter 6

Chapter 6 BU353.docx

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Heather Graham

BU353 Chapter 6 – Loss Control Week 2 Types of Loss Control -Loss control refers to efforts that reduce expected losses -Finding the optimal level of loss control requires consideration of both the benefits and the costs of additional loss control activities Loss Prevention -Numerous activities reduce expected losses by reducing the frequency of losses – Ex. A family building a fence to prevent their child from getting hit by a car -Businesses reduce the probability of being sued under products liability law by designing, manufacturing, and marketing safe products -Safe products are more costly though -An extreme example of loss prevention is to avoid completely the activity that potentially gives rise to the loss – “loss avoidance” -The cost of loss avoidance is the sacrifice of the benefits from the activity that give rise to the potential loss -Loss avoidance would imply that the benefits from the risky activity are less than the costs of the risky activity Loss Reduction -Loss reduction – activities that reduce expected losses by decreasing the size of the loss conditional on a loss occurring -Pre-loss activities occur before a loss; they decrease the magnitude of a loss if one occurs -Post-loss activities occur subsequent to an event that causes a loss Diversification and Expected Indirect Loss -Diversification reduces the probability of very high losses, which can be measured by the maximum probable loss -Diversification can reduce expected indirect losses -If there are indirect losses associated with a large direct loss, segregation of assets nonetheless represents a form of indirect loss control Effects of Insurance on Loss Control -As long as insurance premiums are adjusted to accurately reflect the effects of loss control activities on expected insured losses, insurance coverage will not reduce incentives for loss control -In situations where premiums do not accurately reflect loss control activities, insurance coverage can cause moral hazard Examples of Identification of Benefits and Costs -Ex. Installation of automatic sprinkler systems, installation of safety guards, child-resistant packaging of non-prescription drugs Qualitative vs. Quantitative Decision Making -The best that firms can do is to make educated guesses about the magnitude of benefits and costs Optimal Loss Control when Costs and Benefits are Known -The optimal amount of loss control ideally weighs the costs against the benefits -It is important to refle
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