Question

There are two types of drivers on the road today. Speed Racers have a 5% chance of causing an accident per year, while Low Riders have a 1% chance of causing an accident per year. There are twice as many Speed Racers as there are Low Riders. The cost of an accident is $12,000. a. Suppose an insurance company knows with certainty each driver's type. What premium would the insurance company charge each type of driver? b. Now suppose that there is asymmetric information so that the insurance company does not know with certainty the driver's type. Would insurance be sold if: i. drivers self-reported their types to the insurance company ?

Answer 1

Insurance premiums for Speed Racers and Low Riders can be calculated based on the respective probabilities of causing an accident and the cost per accident. However, with asymmetric information and self-reporting, adverse selection could lead the insurance company to undercharge high-risk drivers and overcharge low-risk drivers, causing market inefficiencies and potential losses for the insurer.

Step-by-step explanation:

Calculating Insurance Premiums

To calculate the insurance premiums for Speed Racers and Low Riders, consider the probabilities and costs of accidents. For Speed Racers, with a 5% chance of an accident costing $12,000, the annual premium would be 0.05 * $12,000 = $600. For Low Riders, with a 1% chance, the premium would be 0.01 * $12,000 = $120.

Adverse Selection in an Asymmetric Information Scenario

With asymmetric information, where the insurance company does not know the driver's type, and if drivers self-report, adverse selection may occur. Low-risk drivers may opt out, leaving only high-risk drivers to buy insurance at the average rate, which can lead to losses for the insurer if the rate does not reflect the higher risk cohort's average claim.