The William Companies (WMB) owns and operates natural gas pipelines that deliver 12% of the natural gas consumed in the United States. WMB is concerned that a major hurricane could disrupt its Gulfstream pipeline, which runs 691 miles through the Gulf of Mexico. In the event of a disruption, the firm anticipates a loss of profits of $65 million. Suppose the likelihood of a disruption is 3% per year, and the beta associated with such a loss is –0.25. If the risk-free interest rate is 5% and the expected return of the market is 10%, what is the actuarially fair insurance premium?

Question

Want to see more full solutions like this?

Answer 1

Textbook Question

Chapter 30, Problem 1P

The William Companies (WMB) owns and operates natural gas pipelines that deliver 12% of the natural gas consumed in the United States. WMB is concerned that a major hurricane could disrupt its Gulfstream pipeline, which runs 691 miles through the Gulf of Mexico. In the event of a disruption, the firm anticipates a loss of profits of $65 million. Suppose the likelihood of a disruption is 3% per year, and the beta associated with such a loss is –0.25. If the risk-free interest rate is 5% and the expected return of the market is 10%, what is the actuarially fair insurance premium?

Expert Solution & Answer

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer to Problem 1P

The insurance premium is $1.88 million.

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Students have asked these similar questions

A flowchart that depicts the relationships among the input, processing, and output of an AIS is A. a system flowchart. B. a program flowchart. C. an internal control flowchart. D. a document flowchart.

Please write proposal which needs On the basis of which you will be writing APR. Write review of at least one article on the study area (Not title) of your interest, which can be finance related study area. Go through the 1. Study area selection (Topic Selection) 2. Review of Literature and development of research of framework 3. Topic Selection 4. Further review of literature and refinement of research fraework 5. Problem definition and research question…

Answer 2

Textbook Question

Chapter 30, Problem 1P

The William Companies (WMB) owns and operates natural gas pipelines that deliver 12% of the natural gas consumed in the United States. WMB is concerned that a major hurricane could disrupt its Gulfstream pipeline, which runs 691 miles through the Gulf of Mexico. In the event of a disruption, the firm anticipates a loss of profits of $65 million. Suppose the likelihood of a disruption is 3% per year, and the beta associated with such a loss is –0.25. If the risk-free interest rate is 5% and the expected return of the market is 10%, what is the actuarially fair insurance premium?

Expert Solution & Answer

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer to Problem 1P

The insurance premium is $1.88 million.

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Answer 3

Textbook Question

Chapter 30, Problem 1P

The William Companies (WMB) owns and operates natural gas pipelines that deliver 12% of the natural gas consumed in the United States. WMB is concerned that a major hurricane could disrupt its Gulfstream pipeline, which runs 691 miles through the Gulf of Mexico. In the event of a disruption, the firm anticipates a loss of profits of $65 million. Suppose the likelihood of a disruption is 3% per year, and the beta associated with such a loss is –0.25. If the risk-free interest rate is 5% and the expected return of the market is 10%, what is the actuarially fair insurance premium?

Expert Solution & Answer

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer to Problem 1P

The insurance premium is $1.88 million.

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Answer 4

Textbook Question

Chapter 30, Problem 1P

The William Companies (WMB) owns and operates natural gas pipelines that deliver 12% of the natural gas consumed in the United States. WMB is concerned that a major hurricane could disrupt its Gulfstream pipeline, which runs 691 miles through the Gulf of Mexico. In the event of a disruption, the firm anticipates a loss of profits of $65 million. Suppose the likelihood of a disruption is 3% per year, and the beta associated with such a loss is –0.25. If the risk-free interest rate is 5% and the expected return of the market is 10%, what is the actuarially fair insurance premium?

Expert Solution & Answer

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer to Problem 1P

The insurance premium is $1.88 million.

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Answer 5

Textbook Question

Answer 6

Textbook Question

Answer 7

Expert Solution & Answer

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer to Problem 1P

The insurance premium is $1.88 million.

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Answer 8

Expert Solution & Answer

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer to Problem 1P

The insurance premium is $1.88 million.

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Answer 9

Expert Solution & Answer

Answer 10

Expert Solution & Answer

Answer 11

Summary Introduction

To determine: Insurance premium.

Introduction:

To manage risk, a firm pays a yearly payment called insurance premium, instead of purchasing the insurance to pay off the losses.

Answer 12

Answer to Problem 1P

The insurance premium is $1.88 million.

Answer 13

Explanation of Solution

Given information:

Loss of profit is $65 million, disruption is 3%, beta is -0.25, risk-free interest rate is 5%, and the expected return is 10%.

The formula to calculate the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL

Here,

P refers to the probability.

E refers to the expected payment of loss.

rL refers to the appropriate cost of capital.

The formula to calculate the cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)

Compute the appropriate cost of capital:

Cost of capital=Risk-free interest rate−Beta(Expected return−Risk-free interest rate)=0.05−0.25(0.10−0.05)=0.05−0.0125=0.0375

Hence, the cost of capital is 0.0375.

Compute the insurance premium:

Insurance premium=P(Loss)×E(Payment in the Event of Loss)l + rL=0.03×$65,000,0001+0.0375=$1.88 million

Hence, the insurance premium is $1.88 million.

Answer 14

Ch. 30.1 - How can insurance add value to a firm?Ch. 30.1 - Prob. 2CC Ch. 30.2 - Prob. 1CC Ch. 30.2 - What are the potential risks associated with...Ch. 30.3 - How can firms hedge exchange rate risk?Ch. 30.3 - Prob. 2CC Ch. 30.4 - How do we calculate the duration of a portfolio?Ch. 30.4 - How do firms manage interest rate risk?Ch. 30 - The William Companies (WMB) owns and operates...Ch. 30 - Genentechs main facility is located in South San...

Videos

Answer to Problem 1P

Explanation of Solution

Want to see more full solutions like this?

Chapter 30 Solutions