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Insurance versus Prepaid Expense

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Suppose that you are a healthy person and you buy a one-year insurance policy against becoming ill. You pay the fair expected value of this policy up front, which is a 1% chance that your expenses will be $100,000, so the premium you would pay is $1,000.

a) How would you characterize this transaction?
b) Now suppose another person has AIDS and knows that his expenses next year will be $100,000 for his treatment. From an insurance company's point of view, what would be the fair premium for this individual?
c) Suppose an insurance company offers him the ability to pay $100,000 up front to administer and pay all of his medical expenses for the next year. How would you characterize this transaction?

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Solution Summary

The solution goes into a great amount of detail related to insurance and prepaid expenses. The response does an very good job of responding to the questions being asked and provide clear and concise answers to the problem. This is a great response for students looking to better understand the differences between hedging and prepaid expenses. Overall, an excellent response.

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(a) This is definitely an insurance transaction. On the general ledger the premium would go into the category of insurance ...

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