You are concerned about the possibility of experiencing on earthquake during the next year. The probability...
You are concerned about the possibility of experiencing on earthquake during the next year. The probability of an earthquake is 0.5%. Your local insurer offers to pay you USD300, 000 if your house is damaged as a result of an earthquake. The insurance policy costs USD1, 500.00. If the inflation rate is forecast to be 10% during the next year, is the price of insurance policy fair.
Homework Answers
Payoff if earthquake happens next year=$300000 and associated probability is 0.5%
Payoff if earthquake does not happens next year=0 and associated probability is (100%-0.5%)=99.5%
Expected payoff for next year= 0.5%*300000+99.5%*0=$1500
Present value of expected payoff =Future value/(1+inflation rate)=1500/(1+10%)=$1363.63
However, the policy costs now is $1500 in comparison with the present value of expected payoff of $1363.63
Hence, insurance policy is overpriced and it's not fair.
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