Velma owns a coffee shop that has an espresso machine, which makes her shop\'s n
ID: 2428848 • Letter: V
Question
Velma owns a coffee shop that has an espresso machine, which makes her shop's net worth $80,000. There is a 4% chance that torrential rains will ruin her espresso machine, reducing the total value of her business to $40,000. What is the expected value of this gamble? What is the minimum premium an insurance company would charge to fully insure the coffee shop against the flood? Velma's certainty equivalent for this risky situation is $77,900. What is the maximum insurance premium she'd be willing to pay for full insurance?
Explanation / Answer
Velma shop's net worth is $80,000. There is a 4% chance of ruining her espresso machine that has a total value of $40,000.
The expected value of this gamble = E(X) = 4%*(40,000) + 96%*(80000) = 78400.
The minimum premium an insurance company would charge to fully insure the coffee shopis the expected loss which is 4%*40000 = 1600.
Velma's certainty equivalent for this risky situation is $77,900. The maximum insurance premium she'd be willing to pay for full insurance is Current worth - Certainty equivalent = 80000 - 77900 = 2100.
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