The Application of Utility Theory in the Decision-Making Process for Investing in ADR Insurance

Abstract

Since most projects today operate on tight budgets, one way to ease the potential for variations from budget is to price Alternative Dispute Resolution (ADR) techniques as an insurance product, which allows the project participants to transfer the risk of incurring unexpected high ADR cost during construction phase to the insurance company. Despite this advantage, many factors are preventing project participants from investing in ADR insurance. For example, on an, expected value (EV) basis, self-insurance almost always appears financially better than insurance premiums because of the insurance company’s underwriting expenses and profit target that are included in the premium charges. However, expected value calculations miss important effects of uncertainty on the participants. In this paper, we borrow utility theory and introduce subjective loss to represent the “risk-averse” attitude of project participants when facing uncertainty. A convex subjective loss function (SLF) is used to translate the impact of ADR costs into utility-equivalent terms. Then the expected subjective loss is translated back to an equivalent certain monetary loss. Comparison between this derived certain monetary loss and the loss from investing in ADR insurance shows that even with the expense and profit loading, there is still an opportunity for a mutually advantageous insurance policy. And this opportunity grows larger as the potential ADR cost increases. Also, a numerical example is presented to illustrate how to structure a subjective loss function for project participants. It is the authors’ hope that this paper could help project participants answer the question in the decision-making process: would they rather try to budget for an unknown cost in a wide range, or pay for insurance and be certain?