Assume that Ambrose Motor Corp. (AMC) estimates next year’s earnings before interest payments as $100 million, provided it does not lose a product liability lawsuit. The probability of a lawsuit is .02 and the payment if it occurs is estimated to be $1 million. From its $100 million in earning, Ambrose expects to pay $60 million on its interest and principal payments, leaving $40 million for shareholders - again provided the company does not lose a product liability suit. Ambrose is trying to decide how to finance risk associated with the potential liability suit.
Questions A-D ought to be answered independently.
A) Assume that AMC has a $2 million/year purchase contract with Lightning Bolts (LB). The contract is for LB to sell to AMC unique motor components on which AMC relies. AMC is certain that if it can reduce the counterparty risk for LB by purchasing product liability insurance, AMC can renegotiate the terms of this contract and reduce the cost of these components by 7%. How much would AMC be willing to pay for the same product liability insurance policy now?
B) If AMC has not transferred risk associated with a product liability suit and such a suit is lost, AMC will be unable to make its promised payments to debtholders, and it will have to renegotiate its debt payments. The legal and administrative costs of renegotiations (including the cost of managers’ time) equal $5 million. Should AMC purchase a liability insurance policy with a $50 million limit for a premium of $1.1 million? Explain.
C) Would the tax status of premiums affect your answer to the previous question? Explain.
D) Consider that AMC is a stock company. The risk manager at AMC (who did not take RMI 300) makes the following argument:
“An additional benefit to insurance not considered here is that risk averse investors would be more willing to invest in AMC if it is insured against product liability losses, because the purchase of insurance reduces the company-specific risk. This increased demand for AMC stock will further increase shareholder value beyond the $40 million that will go to shareholders if no product liability lawsuit is lost.”
Why do we not consider this when making our insurance purchasing decision?