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Strictly positive insurance coverage

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Reference no: EM132471634

Charlie has a von Neumann-Morgenstern utility function u(x)= x?? and initial wealth of $640,000. He faces a 50% chance of losing L = $150,000.

Suppose Charlie is able to choose insurance with any coverage z ∈ [0,1] (i.e. 0 ≤ z ≤ 1). If he buys insurance coverage at level z, he will get reimbursed z*150,000 if the loss occurs.

Insurance coverage at level z costs C(z) = {c0 + z*c1 if z>0} = {0 if z=0}

1) Suppose c0 = 0 and c1 = 75,000. Is insurance at coverage level z>0 fair insurance? What coverage level z* would Charlie choose? Explain

2) Suppose c0 = 100 and c1=75,000. Is insurance coverage level z>0 fair insurance? What coverage level z** would Charlie choose? (Note that c0=100 is an "avoidable fixed cost" which is only paid if he chooses strictly positive insurance coverage.

3) Supposed c0=100 and c1=76,000. Is full insurance, that is coverage level z=1 optimal?

Reference no: EM132471634

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