Suppose that there is a 50–50 chance that a risk-averse individual will have an automobile accident and suffer a loss of $100,000.
Suppose that there is a 50–50 chance that a risk-averse individual will have an automobile accident and suffer a loss of $100,000. a. Calculate the cost of actuarially fair insurance if this individual’s current income is $200,000. Illustrate your answer and show that this individual prefers to fair insurance to self insuring. b. Suppose that two types of insurance policies are available. Policy 1 is fair insurance covering complete loss. Policy 2 is fair insurance covering half of the loss incurred. Demonstrate that this individual will prefer policy 1 to policy 2. c. Suppose that individuals who purchase policy 2 are likely to be more careful drivers, which reduces the cost of an accident to $70,000. In this case, what is the cost of policy2? Explain how some individuals might now prefer policy 2.
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