Question

Questions 14-16 are parts of this question

June’s utility of income is U(I) = I^0.5 (which is the square root of I). Her income is $5000 and she faces a 40% chance of losing $3000.

What is the actuarially fair premium (AFP) to cover this risk? (3)

What is June’s maximum willingness to pay for insurance against this risk? (5)

Suppose June is now pooled with (charged the same premium as) Jim, who faces a 60% chance of losing $3000. The premium charged to each of them is the average of their two AFPs. The government decides to offer premium subsidies to discourage lower risk persons like June from dropping out of this pooled insurance plan. What is the smallest premium subsidy that would ensure that June will voluntarily remain in the plan? (4)

Answer 1