FINA2342CDE Insurance: Theory and Practice

Assignment 1 Answer Key

February 25, 2022

Instructions

1. There are two questions in total. Each question has multiple subquestions. Show your effort
clearly so that you get points for intermediate steps.

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4. Don’t forget to include your full name and UID on the 1st page of your Assignment Submis-
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for your own reference.

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1 Insurance Pricing, Behavioral Bias and Adverse Selec-
tion (50’)
In this exercise, you are asked to analyze the health insurance.
There are a continuum types of people in the society, whose health status can be represented
by x, which lies in between 0 and 1. x follows uniform distribution U [0, 1]. A larger value of x
indicates that the person’s health condition is better. The probability of getting sick and receiving
medical treatment is 0.05 − 0.03x. The expenditure is 200, a constant if one is sick and does not
depend on x.
For example, if x = 1, the probability of getting sick is 0.05 − 0.03 = 0.02. If x = 0.5, the
probability of getting sick is 0.05 − 0.03 × 0.5 = 0.035. All people have an initial wealth of 500.

1. Consider a person A with x = 0.5 buying health insurance that covers the medical treatment.
Suppose A is risk-neutral. (15’)

(a) What is A’s acturially fair price? (5’)

Answer: The probability of getting sick 0.05 − 0.03x = 0.035, and the expenditure is
200. The acturially fair price is 0.035 × 200 = 7.
(b) If A miscalculates her probability of getting sick to be 0.032 and she correctly calculates
her expenditure if being sick, is she able to purchase the insurance? If so, at what price?
Assume the insurers are perfectly competitive and market entry is free. (5’)
Answer: In A’s perception, the probability is 0.032 and the expenditure is 200, so A’s
willingness to pay is 0.032 × 200 = 6.4. Under this premium, the insurer has negative
profit. So, A will not be able to purchase the insurance.
(c) Repeat your analysis in (b) if A miscalculates her probability of getting sick to be 0.038.
(5’)
Answer: In A’s perception, the probability is 0.038 and the expenditure is 200, so A’s
willingness to pay is 0.038 × 200 = 7.6, which is higher than the acturially fair premium
level. Since insurers are competitive and market entry is free, A is able to the purchase
the insurance at the price of 7.
√
2. Consider a person B with x = 0.5 and utility function u(w) = w buying the same insurance.
(15’)

(a) What is the maximum price that B will accept for this insurance, if she correctly cal-
culates her probability of getting sick and the expenditure? (5’)
Answer: Suppose the maximum price is x.
√ √ √
500 − x = 0.035 × 500 − 200 + (1 − 0.035) × 500

Solve for x = 7.86.

(b) How will your answer to (a) change if B miscalculates her probability of getting sick
to be 0.032 and she correctly calculates her expenditure if being sick? Is she able to
purchase the insurance? If so, at what price? (5’)

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 Answer: Under B’s perception, assume the maximum amount B is willing to pay is x.
√ √ √
500 − x = 0.032 × 500 − 200 + (1 − 0.032) × 500

Solve for x = 7.19. This is greater than the acturially fair premium level. Since insurers
are competitive, B can purchase the insurance at the price of 7.
(c) Repeat your analysis in (b) if B miscalculates her probability of getting sick to be 0.038.
(5’)
Answer: Under B’s perception, assume the maximum amount B is willing to pay is x.
√ √ √
500 − x = 0.038 × 500 − 200 + (1 − 0.038) × 500

Solve for x = 8.53. This is greater than the acturially fair premium level. Since insurers
are competitive, B can purchase the insurance at the price of 7.

3. Now we consider the health insurance plan that covers the 80% of the total medical cost.
The premium level is 6. (10’)

(a) If all the people in the society are risk neutral and correctly calculate their probability
of getting sick and the medical expenditure, what is the fraction of people that will
purchase this policy? Is the insurer’s profit positive, negative, or zero?(5’)
Answer: Suppose for people with x breaks even.

(0.05 − 0.03x)(500 − 40 − 6) + (1 − 0.05 + 0.03x)(500 − 6)

= (1 − 0.05 + 0.03x) × 500 + (0.05 − 0.03x)(500 − 200)

Solve for x = 0.42. The fraction of people that will purchase this insurance is 0.42, that
is, all x ≤ 0.42 will purchase this insurance. Among those that purchase the insurance,
the average x is 0.21, so that acturially fair premium level is 200 × (1 − 0.2) × (0.05 −
0.03 × 0.21) = 6.99. With a premium level of 6, the insurer’s profit is negative.
(b) If all the people miscalculates their probability of getting sick as 0.065 − 0.03x, will the
fraction of people that will purchase this policy be higher or lower than your answer
in question 3(a)? Is the insurer’s profit positive, negative, or zero under this scenario?
[Hint: You don’t have to solve for the exact number. Illustrate the economic logic.
](5’)
Answer: When all the people miscalculates their probability of being sick to be higher
than actual, there will be more people that are willing purchase this policy. The ac-
turially fair premium is thus lower, so that insurer earns a positive profit under this
scenario.
√
4. Now consider risk averse buyers. Suppose all the people have utility function u(w) = w.

(a) What is the fraction of people that will purchase the policy in question 3? Denote tha
answer to this question x. Please lay out the equation x needs to satisfy. (5’)
Answer: x satisfies
√ √
(0.05 − 0.03x) 500 − 40 − 6 + (1 − 0.05 + 0.03x) 500 − 6

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 √ √
= (1 − 0.05 + 0.03x) 500 + (0.05 − 0.03x) 500 − 200
(b) Suppose that the insurance industry is monopolistic and the insurer has pricing power
over the health insurance policy. The insurer is considering raising the premium level
further to 6.5. Is it a good idea? Suppose you are a consultant to the insurer. Please
state your opinions, and why or why not. (5’)
Answer: Not necessarily it is a good idea. Raising insurance premium will decrease the
amount of buyers, especially those with relatively good health conditions. The higher
price may eventually reduce the profit of the insurer. To see it more clearly, the average
probability of getting sick among the insurance buyers is 12 x, where x satisfies
p p
(0.05 − 0.03x) 500 − 40 − p + (1 − 0.05 + 0.03x) 500 − p
√ √
= (1 − 0.05 + 0.03x) 500 + (0.05 − 0.03x) 500 − 200
The profit that insurers make is p − 200 × 0.8 × (0.05 − 0.015x) = p + 2.4x − 8. If raising
p decreases x, it does not necessarily increase profits earned by insurers.
Note: If the student plugs in the new premium and solve for the new x and gets a
conclusive answer, the student should get full marks.

2 Moral Hazard and Adverse Selection(50’)

We change the setting of question 1 slightly to discuss the effect of moral hazard. x still affects
the probability of getting sick. The probability of getting sick is 0.05 − 0.03x and the expenditure
is 200 if being sick.
Moreover, health condition x depends on effort. The relation between effort and x is x =
x0 exp(e − 0.5). x0 is a random variable that follows uniform distribution U [0, 1], and e is the effort
level that can take three values: 0, 0.3, and 0.5. The private cost of effort is c(e) = 10e2 .

1. We first consider the case without insurance. (20’)

(a) If the person with x0 = 0.4 is risk-neutral, what will be her optimal effort level? (5’)
Answer:
e 0 0.3 0.5
x 0.243 0.328 0.4
Prob 0.043 0.040 0.038
Expected expenditure 8.54 8.04 7.6
Cost 0 0.9 2.5
Total cost 8.54 8.94 10.1
The optimal effort level is 0.
(b) If the person with x0 = 0.8 is risk-neutral, what will be her optimal effort level? (5’)
Answer:

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 e 0 0.3 0.5
x 0.485 0.655 0.8
Prob 0.0354 0.0304 0.026
Expected expenditure 7.08 6.07 5.2
Cost 0 0.9 2.5
Total cost 7.08 6.97 7.7
The optimal effort level is 0.3.
(c) Compare your answers in 1(a) and 1(b), can you conclude on whether it is easier to
incentivize healthier people or less healthy people to pay effort to maintain their health?
Explain the intuition. Do you think this conclusion is consistent with your real-world
observation? (10’) [Remark: This question gives you a sense of how economists think.
They use models to convey an economic insight and compare with their observations.
If the model delivers a different message with what they observe in the world, they
examine what part of the model leads to the difference and revise the model. ]
Answer: It is easier to incentivize healthier people to pay effort to maintain their
health, because the benefit of paying effort in reducing x is proportional to x0 . The
higher x0 , the larger the benefit is. It is consistent with real-world observation. It is
more useful for a person to maintain her health when the health condition is good. [It
is also acceptable if the student argues it is not consistent with real-world observation,
as long as it makes sense.]

2. Can you provide the range of x0 that will optimally pay effort 0, 0.3, and 0.5 respectively
when they correctly calculate their probability of being sick? (10’)
Answer:

e 0 0.3 0.5
Prob 0.05 − 0.01820x0 0.05 − 0.02456x0 0.05 − 0.03x0
Expected expenditure 10 − 3.64x0 10 − 4.912x0 10 − 6x0
Cost 0 0.9 2.5
Total cost 10 − 3.64x0 10.9 − 4.912x0 12.5 − 6x0

Condition for e = 0 to be optimal:

10 − 3.64x0 ≥ 10.9 − 4.912x0 , 12.5 − 6x0

Solve for x0 ≤ 0.7075.

Conditional for e = 0.3 to be optimal:

10.9 − 4.912x0 ≥ 10 − 3.64x0 , 12.5 − 6x0

Solve for x0 ≥ 0.7075.

Condition for e = 0.5 to be optimal:

12.5 − 6x0 ≥ 10 − 3.6x0 , 10.9 − 5x0

For all x0 ∈ [0, 1], it will not hold.

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 Therefore, for x0 ≤ 0.7075, e = 0 is optimal. For x0 ≥ 0.7075, e = 0.3 is optimal. It is never
optimal to have e = 0.5. Note that e = 0.7075 is indifferent between e = 0 and e = 0.3. It is
ok not to show the answer with strict inequality.

3. We consider a health insurance policy that covers the loss in full, and the premium is 6.5.
For the following questions, assume everyone has x0 = 0.8. (20’)

(a) If buyers are risk neutral, will they purchase the policy? Given the optimal decision of
whether or not to purchase the policy, what is the resulting probability of getting sick,
and what is the expected medical expenditure (before the insurer reimburses, if any)?
(10’)
Answer: The person has x0 = 0.8 and will exert effort 0.3, so her probability of getting
sick is 0.030 without insurance, and her total expected cost is 6.97.
If the person purchases the insurance, she does not need to worry about getting sick
and her total cost is the insurance premium 6, which is smaller than the total expected
cost 6.97. She will purchase the policy. The resulting probability of getting sick is 0.05
after purchasing the insurance, and the expected payout from the insurer is 10.
(b) Is the insurer’s profit positive, negative, or zero? Does there exist a premium level
that satisfies the following two conditions: (i) the buyers are willing to purchase the
insurance; (ii) the insurer earns a nonnegative profit? Explain. (5’)
Answer: The insurer is having a negative profit. There does not exist such a premium
level. For the buyer to be willing to purchase the insurance, the premium has to be
lower than 6.97. But as long as the buyer purchases the insurance, her effort level will
be 0, and the expected expenditure is 10. For the insurer to have a non-negative profit,
the premium should be at least 10.
(c) Suppose your are a consultant to the insurer. What contractual changes will you change
to make the market exist such that the two conditions above hold? Justify your plan
in less than 2 sentences. (5’)
Answer: Coinsurance, deductible. They can reduce moral hazard and induce the
buyer’s effort level to stay at 0.3.