Your house is worth $400,000 and you have $300,000 in a savingsaccount. There is a...

Your house is worth $400,000 and you have $300,000 in a savings account. There is a 1 percent chance of a fire in your house. If the fire occurs, there will be $300,000 in damages to your house.

a. Suppose you do not have fire insurance. If the fire occurs, you will have to pay $300,000 to repair your house. What is the expected value of your wealth (including both the value of your home and your savings account) at the end of the year?

b. We will say that an insurance policy is fair insurance if the premium for the policy equals the expected value of the claims the insurance company will have to pay. An insurance company offers you a fire insurance policy. If a fire occurs, it will pay to repair your home. The premium for the policy is $3,000. Has the insurance company offered you fair insurance?

c. If you are risk averse, would you buy this insurance policy? Defend your answer.

Expert Solution

a. If there is no fire, total value =Value of Home + Amount in Savings Account = $400,000 + $300,000 = $700,000

If there is a fire, there will be damages and $300,000 needs to be paid out. It is assumed that once repairs are done, all damaged will be taken care of. So Value of house remains same but there is no money left in savings account.

So total value in case of a fire = $400,000

Expected Value at end of year = 0.99*$700,000 + 0.01 * 400,000 = $697,000

b. Loss in case of fire = $300,000

Probability of Fire = 1%

So expected loss = 1% * 300,000 + 99% *0 = $3,000

So if the insurance is offered for $3000, it is a fair price to pay.

c. If I am risk averse, then I will buy the insurance since the insurance is fairly priced. As I am risk averse, I will be looking to minimize my loss. Buying the insurance means that in case there is a fire, I do not lose anything. If there is no fire, I lose only $3000 which is negligible compared to the damages in case of fire.

So as a risk averse person, I will always buy the insurance.

As a consumer, I will seek to equalize the marginal utility of wealth across various scenarios. To maintain the same level of wealth in different scenarios, I will look forward to costlessly transfer the value across scenarios which can be done with the help of a fair priced insurance.

Rahul Sunny answered 2 years ago

You own a house worth $400,000 on a river. If the river floods moderately, the house...

You own a house worth $400,000 on a river. If the river floods moderately, the house will be completely destroyed. This happens about once every 50 years. If you build a seawall, the river would have to flood heavily to destroy your house, and this only happens about once every 200 years. What would be the annual premium to the nearest dollar for an insurance policy that offers full insurance? $ What would be the annual premium to the nearest...

You own a house worth $400,000 that is located on a river. If the river floods...

You own a house worth $400,000 that is located on a river. If the river floods moderately, the house will be completely destroyed. This happens once every 50 years. If you build a seawall, the river would have to flood heavily to destroy your house, which happens once every 200 years. What would be the annual premium for an insurance policy that offers full insurnace? For a policy that pays only 75% of the home value, what are your expected...

A house is worth $400,000 in 2020, but was worth $150,000 in 1990. Using prices in...

A house is worth $400,000 in 2020, but was worth $150,000 in 1990. Using prices in 1990 as the base year, know that prices in the economy have grown on average by 1.50 times between 1990 and 2020. (i) If the price of the house had risen at the same rate as average prices, what would the house be worth in 2020? Briefly explain your answer. (ii) Without doing any calculations, but simply based on information in the question and...

a. A house is worth $400,000 in 2020, but was worth $150,000 in 1990. Using prices...

a. A house is worth $400,000 in 2020, but was worth $150,000 in 1990. Using prices in 1990 as the base year, know that prices in the economy have grown on average by 1.50 times between 1990 and 2020. (i) If the price of the house had risen at the same rate as average prices, what would the house be worth in 2020? Briefly explain your answer. (ii) Without doing any calculations, but simply based on information in the question...

You take out a mortgage to buy a house worth $300,000. If the down payment is...

You take out a mortgage to buy a house worth $300,000. If the down payment is 30%, the annual interest rate is 6% compounded monthly, and the term of the mortgage is 30 years, what are your monthly mortgage payments? a) $1,079 b) $1,259 c) $1,439 d) $1,505 e) $1,719

You just found the house of your dreams. The price of the house is $400,000. You...

You just found the house of your dreams. The price of the house is $400,000. You have been qualified to get a mortagage loan with AAA Bank. The mortgage loan is for 30 years at an annual interest rate of 36%. Part (A): How much are your monthly payments for the loan? Part (B): What is the balance of the mortgage loan after2 year(s) of payments? Part (C): After 2 years of payments, you want to add extra money to...

Michael lives on an island and owns a beach house worth $400,000. Of that, $100,000 is...

Michael lives on an island and owns a beach house worth $400,000. Of that, $100,000 is the cost of land and $300,000 is the cost of the structure. The probability that a hurricane destroys his house is 3 percent (he will still own the land). Michael can purchase hurricane insurance at the price of $2 for each $100 of coverage. 1. What is Michael’s contingent consumption bundle if Michael does not purchase insurance? 2. What is Michael’s contingent consumption bundle...

You and your spouse are considering purchasing your first new house. The house price is $300,000....

You and your spouse are considering purchasing your first new house. The house price is $300,000. You will make 10% down payment. The remaining balance can be financed with a 30 year mortgage loan with an annual interest of 6%. A. What is the monthly mortgage payments? B. How much do you need if you are to pay off the loan after 5 years (right after the 60th payment)? C. How much interest (in $) will you save from paying...

A) Tim owns a house worth $400,000. Unfortunately, he faces a 40% risk of a loss...

A) Tim owns a house worth $400,000. Unfortunately, he faces a 40% risk of a loss of $300,000. He is an expected utility maximizer with a utility function u left parenthesis c right parenthesis equals ln left parenthesis c right parenthesis. He can buy insurance coverage K at a price of g per dollar of coverage. If g = 1/2, what is the ratio of consumption in the good state to consumption in the bad state? 0.5 1 1.5 2...

For a nice house for $300,000 (inclusive of closing costs) that you have selected, you want...

For a nice house for $300,000 (inclusive of closing costs) that you have selected, you want to take on a 30-year mortgage loan. The current rate is 3.75% fixed with payments at the start of each month. Your calculations show that you would be paying ($Answer (to the nearest $) in total interest cost during the mortgage period.

Question