Suppose every driver faces a 1% probability of an automobile accident every year
ID: 1166741 • Letter: S
Question
Suppose every driver faces a 1% probability of an automobile accident every year. An accident will, on an average cost each driver S10,000. Suppose there are two types of individuals: those with S60,000 and those with $5,000 in the bank. Assume that individuals with S5,000 in the bank declare bankruptcy if they get in an accident. In the bankruptcy, creditors receive only what individuals have in the bank. What price are individuals with $5,000 in the bank willing to pay for the insurance? Will those with S5,000 in the bank voluntarily purchase insurance? (Remember that there are state laws forcing individuals to purchase auto liability insurance.) a. What is the expected cost of the insurance company of insuring the automobile? b. In event of an accident, what will be the total loss of individuals with $60,000 in the bank if they don't buy insurance? c. In event of an accident, what will be the total loss of individuals with $5,000 in the bank if they don't buy insurance? d. Will the individuals with $60,000 in the bank definitely buy insurance if they are risk averse? e. Will the individuals with $5,000 in the bank definitely buy insurance if they are risk averse?Explanation / Answer
a) The expected cost of the insurance company of insuring the automobile is 1%*$10,000=$100
b)The total loss of individuals with $60,000 in the bank will be 1%*$60,000=$600
c)The total loss of individuals with $5000 will be 1%*$5000=$50 for the insurance
d)They have bigger assets to protect therefore bigger demand for insurance
e) At the actuarially fair price of $100 they will not voluntarily purchase insurance