Problem 1 – A manufacturing representative decides to take an insurance policy t

Question

Problem 1

– A manufacturing representative decides to take an insurance policy to cover possible loses in marketing a new product. If the product is a complete failure, he thinks that a loss of $80,000 would be incurred. If is only moderately successful, a loss of $25,000 would be incurred. Some studies indicate that the probability of a complete failure and a moderate success are 0.01 and 0.05 respectively. Ignoring all other losses, what premium the insurance company should charge for the policy in order to break even?

Solve this problem using the concept of expected value form the point of view of the insurance company.

Explanation / Answer

Expected value can be calculated as follows: E(x) = sum of (x * p(x)) = (0.01 * -80000) + (0.05 * -25000) = - 2050 This means if the insurance company writes this policy there will be a loss of $2050. Hence they should charge a premium of at least $ 2050. Hope this helps you.

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