Question 1

To protect the firm against the loss of earnings if the business operations are disrupted due to fire, accident or some other insured peril, a firm would purchase

Accepted Answer

Business interruption insurance provides coverage for loss of income and expenses related to a business interruption caused by an insured peril, such as fire or accident. It is designed to help a business recover from a disruption in operations and can include coverage for lost profits, rent or mortgage payments, and other expenses necessary to keep the business going while it recovers. Property insurance may cover the physical damage caused by the insured peril, but it may not cover the loss of income or additional expenses incurred as a result of the interruption. Business liability insurance provides coverage for claims of bodily injury or property damage caused by the business, while key personnel insurance provides coverage for the loss of key employees.

Question 2

To insure their assets against hazards such as fire, storm damage, vandalism, earthquakes and other natural and environmental risks, firms commonly purchase

Accepted Answer

Property insurance is specifically designed to cover a company's property against various hazards and natural disasters, making it the best choice for insuring assets against fire, storm damage, vandalism, earthquakes, and other environmental risks. Key personnel insurance covers the loss of key employees, business interruption insurance covers the loss of revenue due to suspended business activities, and business liability insurance covers third-party claims for damages caused by the company.

Question 3

Use the information for the question(s)below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-Assuming that your firm will purchase insurance, what is the minimum-size deductible that would leave your firm with an incentive to implement the new safety policies? Show your calculations.
_____________________________________________________________________________________________
_____________________________________________________________________________________________

Accepted Answer

If the firm is fully insured (no deductible), the insurance company will pay for the loss regardless of whether the safety program is in force or not. Therefore, the end-of-period cash flows will be identical with or without the program and the NPV is -$250 000 reflecting the cost of the safety program.
In order to give the firm the incentive to buy the insurance, the NPV of the safety program must be positive.
Another way of looking at this is to find the point where the PV of the expected deductible equals the cost of the safety program. Mathematically, we have:
(0.08 - 0.03)= $250 000, solving for the Deductible = = $5 250 000
To show that this indeed is the correct answer:
(0.08)= (0.03)- $250 000

Question 4

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-Insurance for large risks that cannot be well diversified has a(n)________, which increases its cost.

Accepted Answer

The answer of Use the information for the question(s)below.
Your firm...

Question 5

Insurance that compensates for the loss or unavoidable absence of crucial employees in the firm is called

Accepted Answer

Key personnel insurance is specifically designed to provide financial support to the company and its employees in the event of death, disability, or other significant losses of a key employee. This allows the company to minimize financial loss and maintain its operations while searching for a replacement or recovering from the loss.

Question 6

Which of the following statements is FALSE?

Accepted Answer

The answer of Which of the following statements is FALSE?
...

Question 7

Which of the following statements is FALSE?

Accepted Answer

This statement is false because insurance for non-diversifiable hazards is generally a negative beta asset. The insurance payment to the firm tends to be larger when total losses are high and the market portfolio is low.

Question 8

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-If your firm is fully insured, the NPV of implementing the new safety policies is closest to:

Accepted Answer

The NPV of implementing the new safety policies can be calculated by comparing the expected loss without the policies to the expected loss with the policies, adjusted for the cost of implementing the policies. Without the policies, the expected loss is 6% of $45 million, which is $2.7 million. With the policies, the expected loss is 3% of $45 million, which is $1.35 million. The difference in expected loss is $2.7 million - $1.35 million = $1.35 million. After subtracting the cost of the policies ($350,000), the NPV is $1.35 million - $350,000 = $1 million. However, since none of the provided options match this calculation directly and considering the context of the question, it seems there might have been a misunderstanding in the calculation process. The correct approach should involve considering the risk-free rate for discounting if applicable, but given the beta of the loss is 0 (indicating no adjustment for risk is needed in discounting), and the straightforward calculation doesn't match any options, the closest correct choice based on the provided options and typical NPV calculation errors would be to recognize a mistake in the calculation explanation. The correct answer should reflect the net benefit or cost of implementing the safety measures, taking into account the reduction in expected loss and the upfront cost. Without the exact calculation leading to one of the provided choices, the selection is based on the logical error in the provided explanation.

Question 9

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-If your firm is uninsured, the NPV of implementing the new safety policies is closest to:

Accepted Answer

To calculate the NPV, we need to discount the future potential loss to present value and compare it to the upfront cost of the safety policies.

Without safety policies:
NPV = -$45 million / (1 + 5%) = -$42.85 million

With safety policies:
NPV = (0.97 x -$45 million) / (1 + 5%) - $350,000 = -$41.91 million

Therefore, the NPV of implementing the new safety policies is approximately $0.94 million higher than not implementing them, making it the best choice.

Question 10

The risk that arises because the value of the futures contract will not be perfectly correlated with the firm's exposure is called

Accepted Answer

Basis risk arises because the value of the futures contract may not perfectly track the underlying asset being hedged. This can be due to differences in timing, delivery locations, and quality. Speculation risk refers to the risk that the futures contract may move in the opposite direction of the firm's exposure, while liquidity risk refers to the risk of not being able to enter or exit a futures contract at a desired price. Commodity price risk is the risk of fluctuations in the price of the underlying commodity being hedged.

Question 11

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-What is the actuarially fair cost of full insurance?
_____________________________________________________________________________________________
_____________________________________________________________________________________________

Accepted Answer

The answer of Use the information for the question(s)below.
Your firm...

Question 12

In reality, market imperfections exist that can raise the cost of insurance above the actuarially fair price and offset some of these benefits. These insurance market imperfections include all of the following EXCEPT:

Accepted Answer

Taxation of insurance payments is not considered an insurance market imperfection that can raise the cost of insurance above the actuarially fair price. The other options, agency costs, adverse selection, and administrative and overhead costs, are all market imperfections that can affect the cost of insurance.

Question 13

Which of the following statements is FALSE?

Accepted Answer

Insurance does not discourage concentrated ownership, so statement D is false. In fact, insurance can make it more attractive for concentrated ownership by reducing the risk associated with holding a large block of shares.

Question 14

Which of the following statements is FALSE?

Accepted Answer

Horizontal integration involves the merger of a firm with a competitor or a firm in the same industry, not with its supplier or customer.Vertical integration involves the merger with a supplier or a customer.

Question 15

'Liquidity risk' is the risk that the firm will not have, or be able to raise, the cash required to meet the margin calls on its hedges.

Accepted Answer

Liquidity risk refers to the risk of not having enough cash on hand or being unable to raise cash quickly enough to meet financial obligations, such as margin calls on hedges.

Question 16

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-An operator of an oil rig has a 0.5% chance of experiencing a catastrophic failure. This failure will cost the operator $500 million. If the risk-free rate is 2%, the expected return on the market is 8%, and the beta of the risk is -1.2, what is the actuarially fair insurance premium?

Accepted Answer

To calculate the actuarially fair insurance premium, we need to use the formula:

Actuarially fair insurance premium = expected loss + risk premium

Expected loss = probability of loss * magnitude of loss

Risk premium = beta * (expected return on market - risk-free rate)

For the oil rig operator:

Expected loss = 0.5% * $500 million = $2.5 million

Risk premium = -1.2 * (8% - 2%) = -7.2%

Actuarially fair insurance premium = $2.5 million - 7.2% * $2.5 million = $2,637,131.

For the firm with the potential loss:

Without new safety policies:
Expected loss = 6% * $45 million = $2.7 million
Risk premium = 0 * (expected return on market - risk-free rate) = 0
Actuarially fair insurance premium = $2.7 million + 0 = $2.7 million

With new safety policies:
Expected loss = 3% * $45 million = $1.35 million
Risk premium = 0 * (expected return on market - risk-free rate) = 0
Total cost = $350,000 + $1.35 million = $1.7 million

Therefore, the best choice is to implement the new safety policies to reduce the potential loss and pay the upfront cost of $350,000.

Question 17

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-An operator of an oil rig has a 0.5% chance of experiencing a catastrophic failure. This failure will cost the operator $500 million. If the risk-free rate is 2%, the expected return on the market is 8%, and the beta of the risk is 0, what is the actuarially fair insurance premium?

Accepted Answer

The answer of Use the information for the question(s)below.
Your firm...

Question 18

To cover the costs that result if some aspect of the business causes harm to a third party or someone else's property, a firm would purchase

Accepted Answer

Business liability insurance provides coverage for costs that arise due to harm caused by the business to a third party or someone else's property. It helps the business to protect itself against potential lawsuits, legal fees, and damages that could result in financial losses. Business interruption insurance provides coverage for lost income due to a disruption in operations, property insurance provides coverage for damage to the business's property, and key personnel insurance provides coverage for the loss of a key employee.

Question 19

Use the information for the question(s)below.
Your firm faces a 6% chance of a potential loss of $45 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $350 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-The value of insurance comes from its ability to reduce the cost of ________ for the firm.

Accepted Answer

Insurance can reduce the cost of potential losses for the firm, which can be seen as a market imperfection. By transferring the risk to an insurance company, the firm can reduce its exposure to losses and potentially save money in the long run.

Question 20

Use the information for the question(s)below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250 000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
-Farmville Industries is a major agricultural firm and is concerned about the possibility of drought impacting wheat production. In the event of a drought, Farmville Industries anticipates a loss of $75 million. Suppose the likelihood of a drought is 10% per year, and the beta associated with such a loss is 0.4. If the risk-free interest rate is 5% and the expected return on the market is 10%, then what is the actuarially fair insurance premium? Show your calculations.
_____________________________________________________________________________________________
_____________________________________________________________________________________________

Accepted Answer

The answer of Use the information for the question(s)below.
Your firm...

Quiz 23: Insurance and Risk Management

To protect the firm against the loss of earnings if the business operations are disrupted due to fire, accident or some other insured peril, a firm would purchase

To insure their assets against hazards such as fire, storm damage, vandalism, earthquakes and other natural and environmental risks, firms commonly purchase

Insurance that compensates for the loss or unavoidable absence of crucial employees in the firm is called

Which of the following statements is FALSE?

Which of the following statements is FALSE?

The risk that arises because the value of the futures contract will not be perfectly correlated with the firm's exposure is called

In reality, market imperfections exist that can raise the cost of insurance above the actuarially fair price and offset some of these benefits. These insurance market imperfections include all of the following EXCEPT:

Which of the following statements is FALSE?

Which of the following statements is FALSE?

'Liquidity risk' is the risk that the firm will not have, or be able to raise, the cash required to meet the margin calls on its hedges.

To cover the costs that result if some aspect of the business causes harm to a third party or someone else's property, a firm would purchase