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Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)
Chapter 25 Insurance and Risk Management
25.1 Insurance
1) To insure their assets against hazards such as ire, storm damage, vandalism,
earthquakes, and other natural and environmental risks irms commonly purchase ________.
A) key personnel insurance
B) business liability insurance
C) business interruption insurance
D) property insurance.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
2) To cover the costs that result if some aspect of the business causes harm to a third party
or someone else's property a irm would purchase ________.
A) business interruption insurance
B) property insurance
C) business liability insurance
D) key personnel insurance
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
3) To protect the irm against the loss of earnings if the business operations are disrupted
due to ire, accident, or some other insured peril a irm would purchase ________.
A) property insurance
B) key personnel insurance
C) business liability insurance
D) business interruption insurance
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
1
4) Insurance that compensates for the loss or unavoidable absence of crucial employees in
the irm is called ________.
A) key personnel insurance
B) business liability insurance
C) property insurance
D) business interruption insurance
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
5) In reality market imperfections exist that can raise the cost of insurance above the
actuarially fair price and ofset some of these beneits. These insurance market
imperfections include all of the following EXCEPT ________.
A) adverse selection
B) agency costs
C) administrative and overhead costs
D) taxation of insurance payments
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
6) Which of the following statements is FALSE?
A) Not all insurable risks have a beta of zero. Some risks, such as hurricanes and
earthquakes, create losses of tens of billions of dollars and may be diicult to diversify
completely.
B) When a irm buys insurance, it transfers the risk of the loss to an insurance company.
The insurance company charges an upfront premium to take on that risk.
C) By its very nature, insurance for nondiversiiable hazards is generally a positive beta
asset; the insurance payment to the irm tends to be larger when total losses are low and
the market portfolio is high.
D) Because insurance provides cash to the irm to ofset losses, it can reduce the irm's
need for external capital and thus reduce issuance costs.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
2
7) Which of the following statements is FALSE?
A) Because insurance reduces the risk of inancial distress, it can relax this tradeof and
allow the irm to increase its use of debt inancing.
B) By lowering the volatility of the stock, insurance discourage concentrated ownership by
an outside director or investor who will monitor the irm and its management.
C) When a irm is subject to graduated income tax rates, insurance can produce a tax
savings if the irm is in a higher tax bracket when it pays the premium than the tax bracket
it is in when it receives the insurance payment in the event of a loss.
D) In a perfect market without other frictions, insurance companies should compete until
they are just earning a fair return and the NPV from selling insurance is zero. The NPV is
zero if the price of insurance equals the present value of the expected payment; in that
case, we say the price is actuarially fair.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
Use the information for the question(s) below.
Your irm faces an 8% chance of a potential loss of $50 million next year. If your irm
implements new safety policies, it can reduce the chance of this loss to 3%, but the new
safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and
the risk-free rate of interest is 5%.
8) If your irm is uninsured, the NPV of implementing the new safety policies is closest to
________.
A) $2.25 million
B) -$.25 million
C) $2.5 million
D) $2.15 million
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
3
9) If your irm is fully insured, the NPV of implementing the new safety policies is closest to
________.
A) $2.15 million
B) $2.5 million
C) $2.25 million
D) -$.25 million
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
10) An operator of an oil well has a 0.5% chance of experiencing a catastrophic failure. This
failure will cost the operator $500 million. If the risk-free rate is 2%, the expected return
on the market is 8%, and the beta of the risk is 0, what is the actuarially fair insurance
premium?
A) $2,450,980
B) $2,500,000
C) $2,550,000
D) $2,314,815
AACSB Objective: Analytic Skills
Author: WC
Question Status: Previous Edition
11) An operator of an oil well has a 0.5% chance of experiencing a catastrophic failure. This
failure will cost the operator $500 million. If the risk-free rate is 2%, the expected return
on the market is 8%, and the beta of the risk is -1.2, what is the actuarially fair insurance
premium?
A) $2,500,000
B) $2,637,131
C) $2,550,000
D) $2,753,304
AACSB Objective: Analytic Skills
Author: WC
Question Status: Previous Edition
12) The value of insurance comes from its ability to reduce the cost of ________ for the irm.
A) adverse selection
B) vertical integration
C) overhead
4
D) market imperfections
AACSB Objective: Analytic Skills
Author: WC
Question Status: Previous Edition
13) Insurance for large risks that cannot be well diversiied has a(n) ________, which
increases its cost.
A) positive beta
B) moral hazard clause
C) negative beta
D) actuarially-biased risk
AACSB Objective: Analytic Skills
Author: WC
Question Status: Previous Edition
Use the information for the question(s) below.
Your irm faces an 8% chance of a potential loss of $50 million next year. If your irm
implements new safety policies, it can reduce the chance of this loss to 3%, but the new
safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and
the risk-free rate of interest is 5%.
14) What is the actuarially fair cost of full insurance?
AACSB Objective: Analytic Skills
Author: JN
Question Status: New
5
15) Assuming that your irm will purchase insurance, what is the minimum-size deductible
that would leave your irm with an incentive to implement the new safety policies?
Answer: If the irm is fully insured (no deductible), the insurance company will pay for the
loss regardless if whether the safety program is in force or not. Therefore, the end of
period cash lows will be identical with or without the program and the NPV is −$250,000
relecting the cost of the safety program.
In order to give the irm the incentive to buy the insurance the NPV of the safety program
must be positive.
Another way of looking at this is to ind the point where the PV of the expected deductible
equals the cost of the safety program. Mathematically we have:
(.08 - .03) = $250,000, solving for the Deductible = = $5,250,000
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
16) Farmville Industries is a major agricultural irm and is concerned about the possibility
of drought impacting corn production. In the event of a drought, Farmville Industries
anticipates a loss of $75 million. Suppose the likelihood of a drought is 10% per year, and
the beta associated with such a loss is 0.4. If the risk-free interest rate is 5% and the
expected return on the market is 10%, then what is the actuarially fair insurance premium?
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
6
25.2 Commodity Price Risk
1) The risk that the irm will not have, or be able to raise, the cash required to meet the
margin calls on its hedges is called ________.
A) liquidity risk
B) basis risk
C) commodity price risk
D) speculation risk
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
2) The risk that arises because the value of a futures contract will not be perfectly
correlated with the irm's exposure is called ________.
A) commodity price risk
B) basis risk
C) liquidity risk
D) speculation risk
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
3) Which of the following statements is FALSE?
A) Horizontal integration entails the merger of a irm and its supplier or a irm and its
customer.
B) Like insurance, hedging involves contracts or transactions that provide the irm with
cash lows that ofset its losses from price changes.
C) For many irms, changes in the market prices of the raw materials they use and the
goods they produce may be the most important source of risk to their proitability.
D) Because an increase in the price of the commodity raises the irm's costs and the
supplier's revenues, these irms can ofset their risks by merging.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
7
4) Which of the following statements is FALSE?
A) Firms generally do not possess better information than outside investors regarding the
risk of future commodity price changes, nor can they inluence that risk through their
actions.
B) Cash lows are exchanged on a monthly basis, rather than waiting until the end of the
contract, through a procedure called marking to market.
C) The irm may speculate by entering into contracts that do not ofset its actual risks.
D) When a irm authorizes managers to trade contracts to hedge, it opens the door to the
possibility of speculation.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
5) Which of the following statements regarding futures contracts is FALSE?
A) Both the buyer and the seller can get out of the contract at any time by selling it to a
third party at the current market price.
B) Futures prices are not prices that are paid today. Rather, they are prices agreed to today,
to be paid in the future.
C) Futures contracts are traded anonymously on an exchange at a publicly observed
market price and are generally very illiquid.
D) Investors are required to post collateral, called margin, when buying or selling
commodities using futures contracts.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
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