Chimnesia has 2 equal-sized groups of people: smokers and nonsmokers. Both types of people have utility U=ln(C) where C is the amount of consumption that people have in any given period. So long as they are healthy, individuals will consume their entire income of $15,000. If they need medical attention (& have no insurance), they will have to spend $10,000 to get healthy again, leaving them with only $5,000 to consume. Smokers have a 12% chance of requiring major medical attention, while nonsmokers have a 2% chance. Insurance companies in Chimnesia can sell two types of policy. The “low deductible” (L-) policy covers all medical costs above $3,000, while the “high deductible” (H-) policy only covers medical costs above $8,000.
a. What is the actuarially fair premium for each type of policy and for each group?
b. If insurance companies can tell who is a smoker and who is a nonsmoker and charges the actuarially fair premiums for each policy and group, show that both groups will purchase the L-policy. Suppose that smoking status represents asymmetric information: each individual knows whether or not they are a smoker, but the insurance company doesn’t.
c. Explain why it is impossible, at any prices, for both groups to purchase L-policies in this setting. Which groups, if any, do you expect to buy L-policies, and at what price?