Payout Period Impact on the Present Value of Claims

A manufacturing firm determines that its payout schedule for workers compensation is as follows:

Year Payout

1 25

2 35

3 40

If the firm insures this exposure, the premium will be $750,000 payable upon inception of the policy. The premium represents 60% loss and 40% administrative expense.

a) Demonstrate and explain if there are any cash flow advantages of retaining this loss if the firms cost of capital is 7%. All calculations must be shown and your recommendations must be fully supported.