Financial Probs a Medical Malpractice

Financial Probs

A medical malpractice insurer has one asset, a $100 million 5-year zero coupon bond, and one liability, a $90 million claim that is to be paid in 5 years. Assume the claim payment will not be affected by changes in interest rates.

Assume the current interest rate for 5-year securities is 5%. Calculate the impact of changes in interest rate of -2%, -1%, +1% and +2% on the net economic value (present value of assets - present value of liabilities) of the insurer.

Interest Rates

Net economic value

11,592,740.74

12,166,529.02

12,762,815.63

13,382,255.78

Net economic value

-1,170,074.89

Calculate the values of the following financial instruments and state a danger to an insurer with respect to a change of interest rate.

a.

A $1 million 10-year zero coupon bond based on a current interest rate of 5%.

P=$613,913.2535 Real value is $714,932.01, assuming a 3.3% inflation rate. An increase in the interest rate would lower price of the bond; if this occurs after purchase, it can be labeled a risk due to the lost opportunity it represents for savings/additional earnings. A decrease in interest rates before purchase poses a more direct and substantial risk, as the price of the bond will increase. A 1% decrease in the interest rate increases the cost of the bond to $675,564.17.

It the interest rate go up, the price of zero coupon bond falls.

b.

A FRA for the party that is paying the fixed interest rate based on a notational amount of $1 million for one year. Current interest rates are 5% and the contract rate is 5%. The value of the contracted payment is $50,000. Should interest rates increase, there would again be a danger in the loss of potential funds, as the fixed rate agreement (i.e. The contract rate) would then be of a lower value than other potential interest earning activities.

c.

The next annual payment on an 6% interest rate cap on a notational amount of $1 million if current rates are 8%. The payment would be 2% of $1 million, or $20,000. If the interest rate drops below 6%, however, no payment will be made at all, and any drop in the interest rate as of the day of the contracted payment -- even a sudden drop limited to that day -- would result in a reduced or potentially vanished payment.

12.