Assume now that there are two types of driver. One half of them are very skilful drivers and each of these has only a 5 per cent chance per year of being involved in a car accident while the other half are less able/careful drivers who each have a 15 per cent chance per year of being involved in an accident.

1. 1. Assume there is perfect information in the market. Calculate an insurance premium for both the very skilful and less careful drivers that would enable mutually beneficial trade. Assume the administrative costs for the insurance company are 5 for both types of customer.
2. 2. Assume now that there is asymmetric information in the market. When a customer purchases a policy, the insurance company does not know if they are skilful or less able drivers. What is the break-even/actuarially fair insurance premium if the insurance company assumes that 50 per cent of its customers are the skilful drivers and 50 per cent are the less able drivers? What premium might the insurance company charge on this basis?
3. 3. Using your answers to parts h. and i, predict what you think will happen in the market. Explain how it illustrates the process of adverse selection. Calculate any lost surplus per customer.
4. 4. Briefly explain some actions that could be taken by customers and suppliers in this market to reduce the chances of adverse selection so enabling mutually beneficial trade.