Adverse Selection (20 points)

1. Imagine a health insurance market with 100 people. In this market in Year 1, 40 people expect to have $0 in health expenses per year, 35 people expect to have $250 in health expenses per person per year, 12 people expect $5,000 in health expenses per person per year, 10 people expect $10,000 in health expenses and 2 people expect $25,000 in health expenses and 1 person expects $40,000 in health expenses over the entire year per person. Assume insurance covers 100% of medical expenses and premiums are equal to expected costs.

What is the expected cost of insurance in year 1? (5 points) Note, use this premium as the Y1 premium across all parts of this problem.

2. In Year 1, how many people would choose to buy insurance and how many would not choose to buy insurance based on the premium and their expected benefits? (5 points)

3. What would the Y2 premium be based on the individuals who choose to buy insurance? (5 points)

4. Describe adverse selection in health insurance in your-own words. (5 points)