Adverse Selection

Please show work and/or explain how you arrived at your answer

Assume 100 people join an insurance pool (a group of people insured through community rating).Based on past experience insuring people in this area and based on the age distribution, the insurance company expects a range of anticipated health insurance claims as shown in the table below.

Number of insuredAnticipated Health Claims/year/person

10$600

10750

10900

101050

101200

101350

101500

101650

102250

104500

1.Year 1:

Customers will buy insurance if their anticipated health claims are greater than the premium. Let's say in the first year, all 100 people purchase the insurance plan. What is the highest premium the insurance company could have charged for all 100 people to have joined?

2.Year 2:

The claims experience of the customers is found to be generally consistent with expectations of the insurance company. What would be the premium in the second year? If those customers who had claims in the first year that were less than or equal to the premium now decide not to continue to buy insurance, how many will continue to be insured in the second year?

3.Year 3:

What would be the premium in the third year? If those customers who had claims in the second year less than or equal to the premium now decide not to continue to buy insurance, how many will continue to be insured in the third year?

4.Year 4:

What would be the premium in the fourth year? If those customers who had claims in the third year less than or equal to the premium now decide not to continue to buy insurance, how many will to continue to be insured in the fourth year?

5.Determine what happens in the first four years if there is a $750 penalty for not carrying insurance.Fill in the table below and write one or two sentences about how and why the outcome is different than the outcome in parts A through D.Assume that nothing else changes, except that now the population decides whether to continue purchasing insurance based not only on their anticipated health claims, but also the penalty they will pay if they do not purchase insurance.

PremiumThreshold forTotal number whoTotal Number

buying insurancehave dropped insuranceRemaining

Yr. 1

Yr. 2

Yr. 3

Yr. 4

6.Provide two possible reasons (with a two sentence explanation for each reason) why insurance customers in the real world may not behave in the ways predicted by parts A through E.