A risk premium is:
A)a payment to an insurer by a policy-holder who faces a potential loss.
B)equal to the purchase price of an insurance policy.
C)the necessary difference between the expected value of a lottery and the payoff of a sure thing to make the decision maker indifferent between the lottery and the sure thing.
D)the difference between the expected value and the variance of a lottery.

Question

Quizplus · Accepted Answer

A risk premium is the extra amount of money that an individual expects to receive in order to take on a risk. In the case of lotteries or uncertain outcomes, the risk premium is the amount necessary to make an individual indifferent between the lottery and a sure thing. Choice A is describing a premium for insurance, not a risk premium. Choice B describes the cost of insurance, which is not the same as a risk premium. Choice D is describing the difference between expected value and variance, which is not the definition of a risk premium. A risk premium is the extra compensation necessary to make an individual willing to take on a risky investment or situation rather than choosing a guaranteed payoff. The risk premium is the difference between the expected value of a risky option, such as a lottery or investment, and the guaranteed payoff of a sure thing. Therefore, choice C is the correct answer as it defines risk premium accurately.

A Risk Premium Is