Question

A person has a net asset of $1 million, including a $300,000 net equity of a house (market value of the house - mortgage). Specifically, the house has a market value of $500,000 including $350,000 for the structure and $150,000 for the land, and a mortgage of $200,000. The person plans to buy $350,000 fire insurance for full coverage of the house. For simplicity, assume that each year the house has a 1% probability of being totally destroyed by fire and a 99% probability of no damage occurring to the house. The person's utility for money is approximately proportional to the quartic root of money with U($100,000,000)=100 and U($0)=0.

7a.(5 points) Draw the decision tree for the person's decision of buying or not buying the insurance.

Answer 1