CatIns Corp.(a fictitious name)sells homeowners' insurance contracts to homes along the shores of the Gulf of Mexico.The contract provides protection against hurricanes and has the following features:
•Annual premium $20,000.
•Fixed deductible $10,000.
•Maximum coverage amount $400,000 (which is less than the value of each home).
•The contract pays for losses from one hurricane in a given year.
Assume that if a hurricane hits,it does the same dollar damage to all homes covered by the insurance policy.
-Suppose that the insurance company CatIns buys reinsurance that pays for hurricane losses to a home over $150,000 for a premium of $5,000 payable to a reinsurance company.Then the profit diagram for CatIns would be similar to:

Question

Quizplus · Accepted Answer

CatIns' profit diagram resembles a bearish call spread because it retains the first $150,000 of losses and transfers losses above $150,000 to the reinsurer, similar to holding a short call option at $150,000 and a long call option at $400,000.