Question

8. Teddy is considering buying flood insurance. The cost of flood insurance is $400 per year. Teddy predicts

that there is a 20% chance that his house will flood and estimates that a flood will cause $1,000 in
damages. If he gets insurance and there's no flood damage, he will lose his $400. However, if he gets
insurance and there is flood damage, the insurance company will pay $1,000 for the damages. Since
Teddy only paid $400 for the insurance, he will essentially save himself $600. What is the expected value
of savings/losses for Teddy buying insurance?

Answer 1

The expected losses are $200 per year

Explanation:

Expected payoff from flood insurance is:

income*probability of flood

$ 1000 * 0.20 = $ 200

But his insurance costs $400 per year, then he will loss: $ 400 - $ 200 = $200 per year.