LeBron has wealth = $200 and has a 75% probability that he requires surgery, that costs $72. LeBron's utility curve over total wealth is given by U(W) = Square Root W.
(a) [1 point] is sam a risk- adverse , risk loving or risk neutral individual? Why?
(b) [1point] what is his expected loss
(c) [2 points] suppose an insurance company incurs an over head expense of $20 per additional client. Can the company profitably insure LeBron?
U = √W
Here it is given that LeBron has wealth, W = $200 and there is a 75% probability that he requires a surgery, that costs $72.
Therefore his expected wealth = $200*25/100 + 128*75/100
= $146
Therefore utility of expected wealth, U(E(W)) = √146 = 12.08
And his expected utility of wealth, E(U(W)) = U(200)*25/100 + U(128)*75/100
= √200*25/100 + √128*75/100
= 12.02
Thus, U(E(W)) > E(U(W))
Therefore, we can see that Sam’s expected utility of wealth is less than utility of expected wealth; i.e. U(E(W)) > E(U(W)).
Therefore Sam is a risk averse person.
U = √W
Or, √W = 12.02
Or, W = 144.48
Therefore insurance company can charge a maximum amount of 200 – 144.48 = $55.52
Now, Company’s total cost = Expected loss of LeBron + Overhead expense of $20 = $54 + $20 = $74
But the maximum amount company can charge LeBron is $55.52
Therefore company will have a loss of $74 - $55.52 = $18.48
Therefore company can not profitably insure LeBron.
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