Question 2.3: Your firm faces a potential $100 million loss that it would ...
Your firm faces a potential $100 million loss that it would like to insure. Because of tax benefits and the avoidance of financial distress and issuance costs, each $1 received in the event of a loss is worth $1.50 to the firm. Two policies are available: One pays $55 million and the other pays $100 million if a loss occurs. The insurance company charges 20% more than the actuarially fair premium to cover administrative expenses. To account for adverse selection, the insurance company estimates a 5% probability of loss for the $55 million policy and a 6% probability of loss for the $100 million policy.
Suppose the beta of the risk is zero and the risk-free rate is 5%. Which policy should the firm choose if its risk of loss is 5%? Which should it choose if its risk of loss is 6%?
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