Asked by Meliza Acosta on Jul 21, 2024
Verified
The Baker family is faced with two possible states.In state 1,they remain healthy and incur no medical expenses.In state 2,their medical expenses will be $8,000.There is a 30% chance that state 1 will occur and a 70% chance that state 2 will occur.An insurance company offers to pay all of their medical expenses for a premium of $6,000.From the Bakers' point of view,this is a fair insurance policy.
Fair Insurance Policy
An insurance agreement that is considered equitable and just, providing a balanced distribution of risks and benefits for both insurer and insured.
Medical Expenses
Costs incurred by individuals for healthcare services, treatments, and medication.
Premium
The amount paid for an insurance policy or an additional cost for receiving better service or goods.
- Understand the economic reasoning that underlies risk aversion and its effects on insurance markets.
- Comprehend the foundational principles guiding the structuring of insurance policies to mitigate undesirable effects.
Verified Answer
KW
kiara waldenJul 22, 2024
Final Answer :
False
Explanation :
To determine if the insurance policy is fair, we need to compare the expected value of their medical expenses without insurance to the expected value of their medical expenses with insurance.
Without insurance:
Expected value = (0.3 x $0) + (0.7 x $8,000) = $5,600
With insurance:
Premium = $6,000
Expected value = (0.3 x $6,000) + (0.7 x $0) = $1,800
Since the expected value without insurance is higher than the expected value with insurance, the insurance policy is not fair from the Bakers' point of view. They would be paying more in premiums than they would be saving in medical expenses.
Without insurance:
Expected value = (0.3 x $0) + (0.7 x $8,000) = $5,600
With insurance:
Premium = $6,000
Expected value = (0.3 x $6,000) + (0.7 x $0) = $1,800
Since the expected value without insurance is higher than the expected value with insurance, the insurance policy is not fair from the Bakers' point of view. They would be paying more in premiums than they would be saving in medical expenses.
Learning Objectives
- Understand the economic reasoning that underlies risk aversion and its effects on insurance markets.
- Comprehend the foundational principles guiding the structuring of insurance policies to mitigate undesirable effects.
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