Genentech\'s main facility is located in South San Francisco. Suppose that Genen

Question

Genentech's main facility is located in South San Francisco. Suppose that Genentech would experience a direct loss of $400 million in the event of a major earthquake disrupting its operations. The chance of such an earthquake is 2.0% per year, with a beta of 0.40.

If the risk-free interest rate is 4.0%, and the expected return of the market is 8.0%, what is the actuarially fair insurance premium to cover Genentech's loss? The actuarially fair insurance premium to coverGenentech's loss is ___ million? (Round 2 decimal places)

Suppose the insurance company raises the premium by an additional 10% over the amount calculated in part (a) to cover its administrative and overhead costs. What amount of financial distress or issuance costs would Genentech have to suffer if it were not insured to justify purchasing the insurance? The amount of financial distress or issuance costs is $___ million (Round 2 decimal places)

Explanation / Answer

Given, P = 0.02 and 1-p = 0.98.

The actuarially fair premium is equal to Expected cost

Expected Cost=p*(loss of income if sick)+(1-p)(loss of income when healthy).

Expected Cost=0.02*400 (+) 0.98*0 = $8 million.

Note:- If we consider the Return also then the answer will be modified as follows:-

Re = 4 + (8-4)*-o.40 = 2.40 %.

So expected cost will be $8 million * 1.024 = $ 8.192 million.

Answer to part (b)

If there is an additional 10 % premium then the Expected cost will be increased by 10 % as follows:-

Expected cost = 8*1.10 = $ 8.80 million.

Expected cost (if Retuen is considered) = 8.80 * 1.024 = $ 9.0112 million

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