Question

7. (6pts) Adverse Selection: Consider a state in which automobile drivers are divided equally into two types of drivers: careful and reckless. The average annual auto insurance claim is $400 for a careful driver and $1,200 for a reckless driver. Suppose the state adopts an insurance system under which all drivers are placed in a common pool and allocated to insurance companies randomly. An insurance company cannot refuse coverage to any driver By law, each insurance company must charge the same price. Assume the price charged by the insurance companies is the break-even price. Predict the price of auto insurance if: ) (1.5pts) Auto insurance is mandatory for all drivers. (Show your work) ) (1.5pts) Auto insurance is voluntary for all drivers? (Show your work.) (1.5pts) Define adverse selection and explain how it applies to this situation. ) (1.5pts) Under a voluntary insurance system, how can the adverse selection problem be eliminated or reduced?

Answer 1

1. let, Auto Insurance Price = p

let population = M

So, for Mandatory Insurance, all drivers needed to buy insurance:

pM = 400*M/2 + 1200*M/2 (for breakeven)

=> p = 1600/2 = 800

2. If voluntary insurance system is there, only reckless drivers will buy the insurance while price will be ascertained keeping entire population in mind:

=> pM = 1200*M/2

=> p = 600

3. Adverse selection is a situation where assymetric information about product quality is exploited by one of the parties(generally seller) for its own benefit. Eg: Insurance companies have knowledge about reckless and careful drivers and thus charge different rates to maximize their benefits or reduce their losses because a reckless driver tend to use insurance much more than a careful person.

4. In voluntary system, the Adverse selection problem can be reduced by limiting the coverage of the insurance only to careful drivers or expecting higher safety standards from reckless drivers failing which their claims can be cancelled.