Your firm faces? a(n) 9% chance of a potential loss of $10 million next year. If

Question

Your firm faces? a(n) 9% chance of a potential loss of $10 million next year. If your firm implements new? policies, it can reduce the chance of the loss to 4%?, but these new policies have an upfront cost of $100,000. Suppose the beta of the loss is? 0, and the? risk-free interest rate is 5%.

d. Let D be the amount of the deductible. NPV of the new policies = –100,000 + 5%(D)/1.05. 0 = -100000+ 5%D/1.05 D = $2.1 million.

What is the actuarially fair price of an insurance policy with the deductible in part ?(d?)?? (Round to the nearest dollar).______________________________

Explanation / Answer

Deductible = $2.1 million.

Thus the insurance company can expect the firm to implement the new policies and so a 4% chance of loss is expected.

In case of loss the amount that will be paid by insurance = 10 million - 2.1 million = $7.9 million.

Premium = 4% of $7.9 million/1.05

= $300,952

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