Suppose you work for an insurance company, and you sell an $120,000 fire insurance policy atan annual premium of $1250. Experience has shown that:
the probability of total loss (due to fire) to a house in that area and of the size of your
customer’s house is .001 (in which case the insurance company will pay the full $120,000 to your customer).
the probability of 50% damage (due to fire) to a house in that area and of the size of yourcustomer’s house is .003 (in which case the insurance company will pay only $60,000 toyour customer).
(For simplicity, we ignore any other partial losses.)
(a) Write down the probability distribution of X, the insurance company’s annual gain from such a policy (i.e., the amount of money made by the insurance company from such a policy).
(b) What is the mean (expected) annual gain for a policy of this type?
(c) What should be the annual premium (instead of $1250) if the company wants to increase the expected gain from a policy of this type by 10%?