MOSTAFA NOR-EL DIN Information Economics BIS Level (4) 7

Given the following utility functions, Identify the risk attitude for each:
1) U = 5I
2) U = I 2
3) U = I 1\2

Example
2
Suppose that your utility function is Or U= 120 I - 2 I
Where I is the amount of income you make (in thousands of dollars) in a given year.
Suppose that you typically make $30,000 per year, but there is a 5 percent chance that, in
the next year you will get sick and lose $20,000 in income due to medical’ cost.

a. what is your expected utility if you do not have insurance to protect against this adverse
event?
b. suppose you can buy insurance that will cover your losses if you get sick.
What would be the actuarially fair premium?
What is your expected utility if you buy the insurance policy?
c. what is the most that you’d be willing to pay for this policy?

A. The expected utility without insurance policy,

Probability of no loss * U(income) + Probability of loss * U(income left after loss)
= {0.95 x (120 (30) – 2 (302)}+{ 0.05 x (120 (10) – 2 (102)}
= 0.95 x 1800 + 0.05 x 1000
= 1760
B.
The actuarially fair insurance premium will be equal to the insurer’s expected payout that will
receive to him.
This will be equal to (the probability that the damage caused) x (amount of damage caused)
= 0.05 x 20,000
= $1,000
If the individual by insurance, he will get 30,000 - 1,000 = 29,000
with certainty (even when the damage caused).

Expected utility with insurance (premium of $1,000), will be

U = (120 * 29) – 2 (292)
= 1792
MOSTAFA NOR-EL DIN Information Economics BIS Level (4) 8
C.
The highest amount that the individual would like to pay will be the amount after which he or
she will get the same amount of utility after the insurance, i.e.
U = (120 * I) – 2 (I 2)
U = 1760
1760 = (120 * I) – 2 (I 2)
Solving the problem for (I)
I = $25,530

Insurance premium = 30,000 – 25,530 = $4,470

Thus, he or she will be willing to give $4,470for this policy.

Loading fee

 an automatically fair insurance premium would charge the expected value of the loss.
 Insurance companies can charge higher premiums than the actuarially fair because people are
risk averse.
The difference between the premium an insurance company charges and the actuarially fair.
premium is called the loading fee.

Loading ratio is the ratio of market insurance premiums divided by benefits paid out.

 The average loading ratio for private insurance companies is about 1.20