Assume that Ambrose Motor Corp. (AMC) estimates next year’searnings before interest payments as $100 million, provided it doesnot lose a product liability lawsuit. The probability of a lawsuitis .02 and the payment if it occurs is estimated to be $50 million.From its $100 million in earning, Ambrose expects to pay $60million on its interest and principal payments, leaving $40 millionfor shareholders - again provided the company does not lose aproduct liability suit. Ambrose is trying to decide how to financerisk associated with the potential liability suit.

What is the expected value of loss associated with the productliability lawsuit?

In a perfect market without transactions costs (taxes are amongpotential transactions costs) where AMC does not value insurerservices, how much would AMC’s shareholders want AMC to pay for $50million of product liability insurance?

Would an insurer be willing to provide this policy for the priceAMC would be willing to pay? Explain.

Next, suppose that AMC’s insurer has an in-house legal expert onproduct liability who can reduce the probability of losing thelawsuit from .02 to .01. If the insurer’s premium loadings add anadditional amount to the premium of 30% of the losses and lossadjustment expense, how much is the premium for $50 million ofcoverage, and would AMC be willing to pay it?