A snow insurance company offers an insurance contract that costs the buyer an upfront premium at...

 

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A snow insurance company offers an insurance contract that costs the buyer an upfront premium at the beginning of 2023. The contract specifies that if it snows more than 2 feet in CT on any single day in 2023, then it pays out $30 to the buyer at the beginning of 2024 (i.e., in one year) and the contract ends. If instead the contract does not end, then the contract is automatically extended to 2024: if it snows more than 2 feet in CT in any single day in 2024, then it pays out $30 at the beginning of 2025 (i.e., in two years) and the contract ends. If the contract has not ended, it is automatically extended to 2025, and so on. The probability in any single year that it snows more than 2 feet in CT on at least one day is 15%, and these probabilities are independent year to year. (a) Suppose the interest rate is 10%. What is the present value of payoffs from the insurance contract to the contract buyer? (b) Suppose the contract price were $20. What does the IRR rule prescribe for this insurance contract from the perspective of the insurance company? How does this differ from the IRR rule from the perspective of the buyer? Explain. A snow insurance company offers an insurance contract that costs the buyer an upfront premium at the beginning of 2023. The contract specifies that if it snows more than 2 feet in CT on any single day in 2023, then it pays out $30 to the buyer at the beginning of 2024 (i.e., in one year) and the contract ends. If instead the contract does not end, then the contract is automatically extended to 2024: if it snows more than 2 feet in CT in any single day in 2024, then it pays out $30 at the beginning of 2025 (i.e., in two years) and the contract ends. If the contract has not ended, it is automatically extended to 2025, and so on. The probability in any single year that it snows more than 2 feet in CT on at least one day is 15%, and these probabilities are independent year to year. (a) Suppose the interest rate is 10%. What is the present value of payoffs from the insurance contract to the contract buyer? (b) Suppose the contract price were $20. What does the IRR rule prescribe for this insurance contract from the perspective of the insurance company? How does this differ from the IRR rule from the perspective of the buyer? Explain.

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Answer a To calculate the present value of payoffs from the insurance contract to the contract buyer we need to discount each potential payout by the ... View the full answer