9. You have a warehouse full of merchandise that you value at $100,000. There is a...

9. You have a warehouse full of merchandise that you value at $100,000. There is a 1% chance that it will burn down in a given year.

a) What is your expected loss in a given year?

b) Suppose there is an alarm you can buy that connects to the nearby fire department. With this alarm, the firefighters will be able to get to the warehouse in time to save $50,000 worth of your merchandise. If you are risk neutral, how much are you willing to pay for the alarm?

c) If you are risk neutral and you have full fire insurance for your warehouse, how much are you willing to pay for it?

d) What is the phenomenon you observe in c) called, and why does it pose a problem?

e) What can the insurance company do to change your behavior in part c)?

Solutions

Expert Solution

Answer A:- The expected loss = $100,000.*0.01 = $1000

Answer B:- An accurately fair price for the alarm will be equal to the amount which can be saved each year by saving the warehouse against the fire

As the saving which can be done is $50,000 and there is a possibility of only 1% to break the fire, so I will pay $50,000*0.01=$500 for the alarm.

Answer C:- For the entire warehouse insurable, I will pay the premium equal to the probability of loss i.e. $1000

Rahul Sunny answered 2 years ago

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