Question

1. Ambrose Motor Corp. has expected cash flow for the next year equal to $ 1 million if it does not lose a product liability lawsuit and $0 if it loses the lawsuit. The CEO would work for $100,000 if he were certain to receive his promised compensation. However, if there is uncertainty for his compensation, he will work for the company only if the company pays him $125,000. The probability of the lawsuit is 90%. Now suppose that Ambrose Motor purchases $400,000 of liability insurance coverage at a premium of $30,000.

1. What is the expected claim cost?

2. What is the premium loading?

3. What is his expected compensation?

Answer 1

a) Expected claim is the amount of the claim expected during the contractual period

Expected claim cost = sum of ( probabilities * claims )

= 0.9 * 1 + 0.1 * 0

= $ 0.9 million

b) Premium loading is the additional amount built into the pure insurance premium to cover the higher costs of losses than initially anticipated

here premium loading is $30000

c)Expected compensation = sum of( Probabilities * compensation )

= 0.9 * 100000 + 0.1 * 125000

= 90000 + 12500

= $ 102,500