Question
Gail owns a property that is subject to the risk of fire. If a fire accident occurs it will cause $4,000 worth of damages. Gail's
Gail owns a property that is subject to the risk of fire. If a fire accident occurs it will cause $4,000 worth of damages. Gail's initial wealth is $13,000. He can choose either low effort 1 = 0, or high effort 2 = 1. The probability of fire accident is 0.75 when 1 = 0 and it is 0.25 when 2 = 1. Gail's utility function is (, ) = ( ) , where denotes net wealth and effort. The insurance company cannot monitor Gail's action. a. If the insurance company sells Gail full insurance, which effort level can it expect from him? What will be the actuarially fair insurance premium?1 What will be Gails expected utility? b. Suppose the insurance policy includes a $2,000 deductible, so in the event of a fire accident Gail will have to pay $2,000. The policy is priced actuarially fairly assuming high effort on Gail's part. Verify that Gail will indeed choose high effort, and that this will give him higher expected utility than in (a)
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