Reference no: EM133313971

Consider a driver with wealth of $20,000. With 1% probability, he will get into an accident that does $15,000 of property damage. When there is no possibility of declaring bankruptcy, an uninsured driver must pay the full cost of the accident. However, with the possibility of filing for bankruptcy, an uninsured driver can protect $10,000 of his wealth (i.e., he has to pay only $10,000 of the damage caused by the accident).

If the driver buys full insurance and gets into an accident, his insurer must pay the full $15,000 in property damage, regardless of whether the driver declares bankruptcy. This is the only cost to the insurer (i.e., there are no fixed costs).

Assume that the driver's utility of having wealth w is √(w), and that there is just one insurance company.

Which of the following statements is true?

a) Regardless of whether the driver can file for bankruptcy, the insurer will be able to make a positive expected profit selling him full insurance.

b) If the driver can file for bankruptcy, the insurer can make positive expected profit selling full insurance to the driver. However, this is no longer true if the driver cannot file for bankruptcy.

c) Regardless of whether the driver can file for bankruptcy, the insurer won't be able to make a positive expected profit selling him full insurance.

d) If the driver cannot file for bankruptcy, the insurer can make positive expected profit selling full insurance to the driver. However, this is no longer true if the driver can file for bankruptcy.

e) More than one of the above statements could be true.