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CMA Final · Strategic Performance Management and Business Valuation · Risk Management

Aarav Textiles estimates that a fire could damage its warehouse stock. Probability of a fire in a year is 2%, and the loss if it occurs is Rs 50,00,000. Insurance cover costing Rs 80,000 per year would fully indemnify the loss. Based only on expected loss, what is the annual expected loss and the comparison with the premium?

Expected annual loss is Rs 1,00,000, obtained by multiplying the 2% probability by the Rs 50,00,000 loss. Since the Rs 80,000 premium is lower than this expected loss, insurance is financially attractive on an expected value basis.

  1. ARs 1,00,000; premium is lower than expected lossCorrect
  2. BRs 1,00,000; premium is higher than expected loss
  3. CRs 80,000; premium equals expected loss
  4. DRs 2,50,000; premium is lower than expected loss

Explanation

Expected loss = 2% x 50,00,000 = Rs 1,00,000. The premium of Rs 80,000 is below this, so on expected value alone insurance is favourable. Option with Rs 2,50,000 wrongly uses a different base.

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