Recognizing that Amazon does not in fact operate in a perfect market, Amazons risk manager uses risk management concepts and tools learned in RMI 300 to analyze how risk management adds value to the company. For questions 4-6, evaluate each of the scenarios independently (i.e. do not use information in question 4 to answer question 5).

1. Suppose Amazons insurer has an in-house legal expert who can reduce the probability of a lawsuit from 0.05 (5%) to 0.025 (2.5%). If the insurers premium loadings add an additional amount to the premium equal to 20% of the losses and loss adjustment expense, how much is the premium for $50 million of coverage? Should Amazon be willing to purchase this insurance?

2. Assume Amazon has a $20 million purchase contract with Sharp, a supplier of unique motion sensors. Sharp faces counterparty risk since it does not have perfect information about Amazons ability to uphold the contract. If Amazon purchases product liability insurance, the company can negotiate better contract terms with Sharp and reduce the cost to purchase the sensors by 8%. How much should Amazon be willing to pay for the insurance?

Amazon should be willing to pay for the 2.5 million in question 1 and the 1.6 million here. They should be willing to pay $4,100,000 for the insurance

3. Assume that if Amazon has not transferred risk associated with a product liability lawsuit, the firm will have to seek external capital to pay for losses (i.e. Amazon has insufficient internal funds to cover the entire cost of the lawsuit). If sued, Amazon will take out a loan for the entire $50 million, and legal and administrative costs will equal $1,000,000.
   1. Should Amazon purchase $50 million of insurance coverage for a premium $2,550,000? Explain.

2. Would the tax status of premiums affect your answer to part (a)? Explain.

4. Having completed an analysis of how risk management adds value to the company, Amazon (Ring)s risk manager further reasons that there is an additional benefit to corporate risk management. The risk manager makes the following argument:

An additional benefit to insurance not considered here is that risk-averse investors would be more willing to invest in Amazon if it is insured against product liability losses because the purchase of insurance reduces the company-specific risk. This increased demand for Amazon stock will further increase shareholder value beyond the $40 million that will go to shareholders if no product liability lawsuit is lost.

Explain the flaw in the risk managers logic.