Your house is worth $400,000 and you have $300,000 in a savings account. There is a 1 percent chance of a fire in your house. If the fire occurs, there will be $300,000 in damages to your house.
a. Suppose you do not have fire insurance. If the fire occurs, you will have to pay $300,000 to repair your house. What is the expected value of your wealth (including both the value of your home and your savings account) at the end of the year?
b. We will say that an insurance policy is fair insurance if the premium for the policy equals the expected value of the claims the insurance company will have to pay. An insurance company offers you a fire insurance policy. If a fire occurs, it will pay to repair your home. The premium for the policy is $3,000. Has the insurance company offered you fair insurance?
c. If you are risk averse, would you buy this insurance policy? Defend your answer.