A Model for the Determination of “Fair” Premiums on Lease Cancellation Insurance Policies

Authors

  • JAMES S. SCHALLHEIM,

  • JOHN J. McCONNELL

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    • Graduate School of Business, University of Utah and Purdue University, respectively. In developing this paper, the authors have benefited from stimulating conversations with Kenneth Dunn, Robert Geske, and Steven Manaster. Comments by Sanjai Bhagat, Jim Brickley, Fikry Gahin, William Kracaw, Rene Stultz, and participants at finance workshops at the University of Utah and Washington State University also have been most helpful. Financial support for this research was provided to John McConnell by the Eli Lilly Corporation.


ABSTRACT

Lease cancellation insurance protects the lessor against early termination of a cancellable operating lease. This paper presents a contingent claims model for determining the “fair” premium for this type of insurance policy. Comparative statics are considered, and some numerical examples are presented to illustrate the model. Among other things, the insurance premium is sensitive to the expected rate of economic depreciation of the leased asset and to the leased asset's systematic and nonsystematic risk.

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