Teddy is considering buying flood insurance. The cost of flood insurance is $400 per year. Teddy predicts that there is a 20% chance that his house will flood and estimates that a flood will cause $1,000 in damages. If he gets insurance and there's no flood damage, he will lose his $400. However, if he gets insurance and there is flood damage, the insurance company will pay $1,000 for the damages. Since Teddy only paid $400 for the insurance, he will essentially save himself $600. What is the expected value of savings/losses for Teddy buying insurance?

Question

(1 point)
Responses

negative 200 dollars
Image with alt text: negative 200 dollars

$600
$600

negative 400 dollars
Image with alt text: negative 400 dollars

$120

Answer 1

The expected value of savings/losses for Teddy buying insurance can be calculated by considering the probability of each outcome.

If there is no flood damage:
Probability = 80%
Savings = -$400

If there is flood damage:
Probability = 20%
Savings = $600

Expected value = (0.8 x -400) + (0.2 x 600)
Expected value = -320 + 120
Expected value = -$200

Therefore, the expected value of savings/losses for Teddy buying insurance is negative $200.