Genentech\'s main facility is located in South San Francisco. Suppose that Genen
ID: 3112039 • Letter: G
Question
Genentech's main facility is located in South San Francisco. Suppose that Genentech would experience a direct loss of $350 million in the event of a major earthquake disrupting its operations. The chance of such an earthquake is 1.0% per year, with a beta of 0.35.
a. If the risk-free interest rate is 6.0%, and the expected return of the market is 11.5%, what is the actuarially fair insurance premium to cover Genentech's loss?
b. Suppose the insurance company raises the premium by an additional 18% 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?
Explanation / Answer
a) Actuarially fair insurance premium = [Pr.Loss) x E(Payment in the event of loss)]/(1+Cost of Capital) Cost of Capital = Rf + Beta x (Rm -Rf) Risk Free Rate Rf = 6.00% Expected Market Return Rm = 11.50% Beta -0.35 Cost of Capital = Rf + Beta x (Rf -Rm); 6%+ -0.35 x (11.5%-6%) 4.075% Probability of Loss (Pr.Loss) 1.00% Payment in the event of Loss $350 Million Insurance Premium = (1% x $350Million)/(1+4.075%) $3.37 Million b) Additional Overhead Cost 18% New Insurance Premium = $3.37x (1+18%) $3.98 Million The amount of financial distress or issuance costs 18% x $350 $63 Million NPV(buy insurance) = -$3.98+ (1%x($350 + $63)/(1+4.075%) 0 Buying insurance is positive NPV for Genentech if it experiences distress or issuance costs equal to 15% of the amount of the loss.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.