Question

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

Expected payoff from insurance:

$1000*0.20 = $200

0*0.80=0

Expected payoff is $200

He pais $400 for insurance.

He gains only if there is a flood, but he has an expected loss of $200