Alejandro lives in southern California and has a total wealth of $500,000 that consists of his home, worth $100,000, and $400,000 in cash. He keeps the cash in a safe deposit box at his local bank, so it is completely safe. At any given time, there is a 10% chance that his house will be completely destroyed by an earthquake and be worth nothing and a 90% chance that nothing will happen to it. Alejandro buys insurance guaranteeing that his house will be restored to its original condition, should anything happen to it. The insurance premium is $2,000. Consequently, assuming other things remain unchanged, his future:

Question

Quizplus · Accepted Answer

Alejandro's initial wealth is $500,000. If he pays a $2,000 insurance premium, his wealth is reduced to $498,000. The insurance ensures that his house will be restored if destroyed, so there's no risk of losing the house's value. Thus, his wealth is $498,000 for sure, not just expected.

Alejandro Lives in Southern California and Has a Total Wealth