Part A. Answer each of the following questions in a short composition.
1. Richie Rich, a millionaire, and Penny Poor, a welfare recipient, are both at high risk for automobile accidents. Richie owns a fast sports car, and he likes to drag race it with his friends on the weekends. Penny has a small junker that has an extra-powerful engine, which she regularly tests as she speeds to her part-time job every day. Auto liability insurance is not compulsory in their state. Explain why Penny might have less incentive to purchase liability insurance than Richie.
2. Christopher is an avid bicycle enthusiast. He participates in Ride the Rockies, a popular bike race in the Colorado mountains. During the race, he slips on some gravel when going down a hill at 50 miles per hour and is thrown from his bike. His bike helmet cracks and he has serious head injuries. If he survives, under what theories can he sue the bike helmet manufacturer?
3. Stinky Inc. has a factory which emits air pollutants which could have long-term effects on the environment and also smell terrible. This reduces the values of surrounding property. Stinky has estimated that the cost of installing anti-pollution devices is $500,000. Fines are imposed by the EPA for exceeding limits on certain types of emissions but these are only $1,000 per year. Considering liability rules, transaction costs and information availability, analyze the optimality of installing the anti-pollution
Part B. Answer each of the following questions in three to five sentences.
1. Define each of the following terms:
c. Policy limit
2. When will minimizing the cost of risk also maximize the value of the firm?
3. Define each of the following homeowner's insurance-related acronyms:
4. Why are workers willing to accept a pay-as-you-go unfunded plan for Social Security but not for private pension plans?
5. For each of the following examples of product liability cases, explain what type of defect is being alleged.
a. Liability of an off-road auto manufacturer for failing to install a roll bar to minimize injuries if the vehicle overturns.
b. Liability of a baby food manufacturer for pieces of glass found inside some of the jars.
c. Liability of a pharmaceutical company for side-effects of a drug.
6. Business risk is comprised of (a) price risk~ (b) credit risk~ and (c) pure risk. Define these terms and give an example of each.
7. What is the impact of the United States Tax Code on the amount of capital held by insurers?
8. Describe the similarities between "segregation of exposures units" and risk pooling.
9. (a) List the six coverages provided in the Homeowner's 3 policy.
(b) Describe the difference between "named perils" and "open perils" coverage basis.
10. John's employer offers a qualified 401(k) plan and will match John's contributions up to a limit of 3% of his salary. John's salary is $20,000 and he contributes 3% the first year. Assuming that all contributions are made at the end of the year, the plan earns a 15% pre-tax return, and that John is in the 28% tax bracket, how much will he have in the plan at the end of one year? What is John's realized rate of return?