Question

In calculating insurance premiums, the actuarially fair insurance premium is the premium that results in a zero NPV for both the insured and the insurer. As such, the present value of the expected loss is the actuarially fair insurance premium. Suppose your company wants to insure a building worth $295 million. The probability of loss is 1.28 percent in one year, and the relevant discount rate is 3.2 percent. |

a. |
What is the actuarially fair insurance premium? |

b. |
Suppose that you can make modifications to the building that
will reduce the probability of a loss to .90 percent. How much
would you be willing to pay for these modifications? (Do
not round intermediate calculations and enter your answer in
dollars, not millions of dollars, rounded to the nearest whole
dollar, e.g., 1,234,567.) |

Answer #1

a)

Insurence premium = Valueof asset * Probability of loss/(1+Discount rate)

=$295,000,000*1.20/(1+0.032)

=$354,000,000/1.032

=$343,023,256.

Therefore, the expected fair insurance premium is $343,023,256.

b)

Insurence premium = Valueof asset * Probability of loss/(1+Discount rate)

=$295,000,000*0.0090/(1+0.032)

=$2,655,000/1.032

=$2,572,675.

Thus,the revised insurence premium will be $2,572,675.

Payment for modifications = $343,023,256-$2,572,675

=$3,404,450,581

Therefore.the maximum amount the company would be willing to pay for modifiation is $3,404,450,581.

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