Question

Assume that Ambrose Motor Corp. (AMC) estimates next year’s earnings before interest payments as $100 million, provided it does not lose a product liability lawsuit. The probability of a lawsuit is .02 and the payment if it occurs is estimated to be $50 million. From its $100 million in earning, Ambrose expects to pay $60 million on its interest and principal payments, leaving $40 million for shareholders - again provided the company does not lose a product liability suit. Ambrose is trying to decide how to finance risk associated with the potential liability suit.

What is the expected value of loss associated with the product liability lawsuit?

In a perfect market without transactions costs (taxes are among potential transactions costs) where AMC does not value insurer services, how much would AMC’s shareholders want AMC to pay for $50 million of product liability insurance?

Would an insurer be willing to provide this policy for the price AMC would be willing to pay? Explain.

Next, suppose that AMC’s insurer has an in-house legal expert on product liability who can reduce the probability of losing the lawsuit from .02 to .01. If the insurer’s premium loadings add an additional amount to the premium of 30% of the losses and loss adjustment expense, how much is the premium for $50 million of coverage, and would AMC be willing to pay it?

Answer 1

Solution:

(a).Answer:

E (probability of loss associated with the product liability lawsuit) = .02 (50,000,000) = $1,000,000

Answer :( b)

  In a perfect market without transactions costs (taxes are among potential transactions           costs) where AMC does not value insurer services,

In a perfect market without transaction casts AMC's shareholders would want AMC to pay up to $1,000,000 for $50 million of product liability insurance because AMC does not value insurer services meaning that they are risk-neutral and will only pay up to expected value of loss.

Answer :( c)

Would an insurer be willing to provide this policy for the price AMC would be willing to pay? Explain.

Earnings are 100 million

Lawsuit probability =.02,

Loss payment = 50 million,

Expected loss = 1 million

Interest= 60 million

Net = EDIT - Interest - expected probability of loss

Net =100 - 60 - 0.02'50 = 39 million

Shareholders pay = 40 million

Thus, AMC is selling a policy costing 539 million for the cost of S40 million making 51 million, while this Is a negligible edge, It Is a positive edge If all costs are spoken to, therefore, they should will go up against the undertaking in case they have endless capital or if there are no endeavors that have a more noticeable edge.

Answer :( D)

Earnings are 100 million Lawsuit probability =.01.

Loss payment = 50 million,

Expected loss = 500.000 Interest- 60 million

Net

• EBIT - Interest - expected probability of loss

Net =100 - 60 - 0.01*50 39.5 million

Shareholders pay • 40 million