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

What is the origin of Biblical ethics and how researchers can demonstrate Biblical ethics? How researchers can demonstrate Biblical ethics when conducting a literaturereview? How researchers can demonstrate Biblical ethics when communicating with aresearch team or university committee?

Equipment is worth $339,976. It is expected to produce regular cash flows of $50,424 per year for 18 years and a special cash flow of $75,500 in 18 years. The cost of capital is X percent per year and the first regular cash flow will be produced today. What is X? Input instructions: Input your answer as the number that appears before the percentage sign. For example, enter 9.86 for 9.86% (do not enter 0986 or 9.86%). Round your answer to at least 2 decimal places. percent

You want to buy equipment that is available from 2 companies. The price of the equipment is the same for both companies. Silver Leisure would let you make quarterly payments of $3,530 for 7 years at an interest rate of 2.14 percent per quarter. Your first payment to Silver Leisure would be today. Pond Leisure would let you make X monthly payments of $18,631 at an interest rate of 1.19 percent per month. Your first payment to Pond Leisure would be in 1 month. What is X? Input instructions: Round your answer to at least 2 decimal places.

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