Insurance company make profit given homeowners choice

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Reference no: EM13984416

Suppose the typical Florida resident has wealth of $500,000 of which his or her home is worth $100,000. Unfortunately Florida is infamous for its hurricanes, and it is belived there is a 10% change of a hurricane that could totally destroy a house (a loss of $100,000). However, it is possible to retrofit the house with various protective devices (shutters, roof bolts) for a cost of $2,000. This reduces the 10% chance of a loss of $100,000 to a 5% chance of a loss of $50,000. The homeowner must decide whether to retrofit and thereby reduce expected loss. The problem for an insurance company is that is does not know whether the retrofit will be installed and therefore cannot quote a premium conditioned on the policyholder choosing this action. Nevertheless, the insurance company offers the following two policies from which the homeowner can Choose. 91) The premium for insurance covering total loss is $1,500. The typical home over has a utility function equal to square root of wealth. Will the homeowner retrofit the house, and which insurance policies will the home over buy? Will the insurance company make a profit (on average) given the homeowners choice?

Reference no: EM13984416

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