Choice under Uncertainty Past Year Questions (Solution)

2010 Zone A

1.Kate’s utility depends on her income I. Her utility function is given by

u( I) = 𝑰

Kate’s income is uncertain. With probability 0.8 her income is 100 and with
probability 0.2 her income is 64.

(a) What is Kate’s expected utility? [5 marks]

𝐸𝑢 = 0.8 100 + 0.2 64 = 9.6

(b) Show geometrically that Kate would be prepared to pay a positive

premium if her income is insured fully. [5 marks]

You should draw a picture similar to the following

You could draw the CE point and point out that since expected
income, which is given by E(I) = 0.8 x 100 + 0.2 x 64 = 92.8, exceeds the certainty
equivalent, the premium is positive.

(c) Calculate the maximum premium that Kate would be willing to pay to
insure her income fully. [5 marks]

To see the maximum premium she would pay, calculate the certainty equivalent (CE)
of the lottery she is facing.
𝐶𝐸 = 9.6 , 𝐶𝐸 = 92.16
The maximum premium Kate is willing to pay is 100 − 92.16 = 7.84
(d) What is the smallest insurance premium that the insurance company will
accept in order to fully insure Kate’s income? [5 marks]
Assuming the insurance company is risk neutral, it must break even. So the minimum
premium (or fair premium) is P such that P equals expected payout, which is
0.2 100 − 64 = 7.2

2011 Zone A
2.Kim owns a house worth 100,000. There is a probability of 0.1 that the house
could be destroyed by fire during the course of a year. Kim’s utility function is

u( W) = 𝑾

where W denotes wealth. Suppose Kim is offered full insurance by an insurance

company. Assuming that Kim has no other wealth, what is the maximum he
would be willing to pay for such an insurance policy? (5 marks)

First, calculate the certainty equivalent (CE). This is given by u (CE) = Eu . Here
expected utility is
𝐸𝑢 = 0.1 0 + 0.9 100000 = 0.9 100000
CE = (0.9 100000)! = 0.81 (100000) = 81000

The maximum premium Kim is willing to pay is 100000 − 81000 = 19000

2011 Zone B
3.Oscar’s utility depends upon his wealth W. His utility function is

u( W) = 𝑾

Oscar’s current wealth is 100, but he faces the risk of losing 60 with probability
1/3.
An insurance company makes him the following offer: for every dollar that
Oscar pays as premium, the insurance company will pay him 3 if the loss
occurs.

i. How much insurance will Oscar buy? [5 marks]

ii. Oscar’s friend John has the same current wealth as Oscar and faces
exactly the same risk. However, his utility function is

v(W) = ln W

If the insurance company makes the same offer to John, how much
insurance will he buy? [5 marks]

The crucial point to realise is that the insurance is actuarially fair. You should also
know that if insurance is offered at a fair premium, a risk averse person would
optimally buy full insurance. Once you know this, and you identify that Oscar and
John are both risk averse, the answer to both parts are immediate: both Oscar and
John buy full insurance.

To see that the insurance is fair, suppose the premium is P. Since a loss occurs with
probability 1/3, the insurance company's expected profit is P – 1/3(3P) = 0 . Therefore
the insurance is actuarially fair.

Since Oscar is risk averse, he will buy full insurance, i.e. get a coverage of 60 which
costs 20. In other words, P is given by 100 - P = 40 + 3P - P which implies that Oscar
will choose to pay a premium of P = 20.

John is also risk averse, since v (W ) is a concave function of W : v’’ (W ) = -𝑊 !! < 0.

Since the insurance scheme is actuarially fair, John will also buy full insurance by
choosing a premium of 20

2012 Zone A

4. Individuals differ in their state of health: half the population is healthy and
the other half is unhealthy. Initial wealth for all individuals is 100. Any
individual (regardless of health) becomes sick with probability 0.4. The state of
health affects the cost of getting sick: medical expenses for healthy people, if
they become sick, amount to 19 (reducing wealth to 81); medical expenses for
unhealthy people, if they become sick, are 36 (reducing wealth to 64). The Initial
wealth of 100 remains unchanged if an individual does not get sick. Each
individual’s utility function is

U(Y) = 𝒀𝟏/𝟐

where Y denotes wealth. Suppose an insurance company is available to provide

insurance.

(a) What is the maximum premium that a healthy individual would be willing
to pay for full insurance? [5 marks]
Expected utility of a healthy person is
𝐸𝑈 = 0.4 81 + 0.6 100 = 9.6

𝐶𝐸 = 9.6 , 𝐶𝐸 = 92.16
The maximum premium is 100 − 92.16 = 7.84

For the next three parts, assume that while each individual knows whether he
or she is healthy, the insurance company does not have this information.

(b) Suppose everyone is required by law to purchase insurance from the same
insurance company. The insurance company provides full insurance to all
individuals and charges an average premium. What premium must the
insurance company charge to break even? [5 marks]

Fair premia for the healthy and the unhealthy correspond to their respective expected
medical expenses.
 Fair premium for healthy people is 0.4 19 = 7.6
Fair premium for unhealthy people is 0.4 36 = 14.4
Average premium is 0.5 7.6 + 0.5 14.4 = 11

(c) If restrictions are lifted so that individuals may opt out of insurance, does
the insurance company need to charge a different price compared to part
(b) to break even? Explain. [5 marks]

Healthy people will not want to purchase insurance because 11>7.84. Therefore, the
insurance company only has unhealthy people as clients, and therefore must increase
the premium to 14.4 to break even.

(d) Is the insurance market in part (c) efficient? If your answer is yes, explain
why the market is efficient. If the answer is no, explain the problem that
prevents the market from being efficient. [5 marks]

The insurance company is willing to provide insurance at any premium at or above

7.6, and healthy people are willing to pay a maximum of 7.84. There are clearly gains
from trade that cannot be exploited. Hence the market is inefficient. The problem
arises from the fact that an individual’s health is private information. Your answer
should clarify this problem of adverse selection

2012 Zone B

5. Rai has wealth 81, but if she becomes ill, she will have to pay medical bills,
reducing her wealth to 36. The probability that Rai will fall ill is 1/3. Rai’s utility
function is given by

u( W) = 𝑾

where W denotes wealth. Rai has the option of buying insurance coverage
for illness from an insurance company.

i. What is the maximum premium that Rai is willing to pay for full insurance?
[5 marks]
! !
Expected utility is 𝐸𝑈 = ! 81 + ! 36 = 8
Therefore 𝐶𝐸 = 8, 𝐶𝐸 = 64
Therefore, the maximum premium is 81 − 64 = 17
ii. What is the minimum premium that the insurance company would
accept to provide full insurance? [5 marks]

The fair premium is equal to expected payout, which is 1/3 (81 – 36) = 15

𝑿
iii. Suppose Rai can buy X units of cover by paying a premium of 𝟑
(i.e.the insurance company pays X to Rai if she falls ill, and Rai pays the
𝑿
insurance company 𝟑 whether she is ill or not ill). What is the optimal
choice of X by Rai? (5 marks)

Pay X/3 and you get X if the bad state of the world occurs. Notice that the premium
(X/3) is 1/3 of the coverage (X). This is simply the probability of the bad state of the
world occurring. So the insurance is actuarially fair

You can also note that since the insurance company expected profit is

𝑿 𝟏
𝟑
−𝑿 𝟑
=𝟎

So the insurance is offered at fair premium.

Thus, Rai will buy full insurance since he is risk averse. So X = 81 – 36 = 45.

2013 Zone A

6. Jo has a wealth of 10,000, but faces the risk of losing 3600 with probability
0.2. An insurance company offers Jo the following scheme: in exchange for
a premium of X, the insurance company would pay out 5X in the event of
a loss.

i. Suppose Jo’s utility function is given by

u(w) = ln w

where w denotes wealth. What is the optimal choice of X for Jo?

[5 marks]

For any X , the insurance company’s profit is

X – (0.2) (5X) = 0

Therefore the scheme is a fair insurance scheme. Since Jo is risk averse, she would
choose full insurance. This implies 10000 - X = 6400 + 5X -X which implies
5X = 3600, or X = 720.
ii. Now suppose Jo’s utility function is given by
𝟏
u(w) = 𝟏 − 𝒘

where w denotes wealth. What is the optimal choice of X for Jo in this

case? [5 marks]

The utility function is different, but this is still concave, i.e. Jo is still risk averse.
Therefore, under fair insurance Jo will still choose full insurance, i.e. X = 720.

2015 Zone A

7a) Lee does not have insurance against car theft. His car is worth 45. He can
park his car on the street or pay to park in a garage. If parked on the street,
the car is stolen with probability 1/3. If parked in a garage, the car is safe
from theft. Including the value of his car, Lee has a wealth of 81. His utility
from wealth W is u(W) = 𝑾

i. Calculate the maximum amount that Lee is willing to pay to park in a

garage. [5 marks]

Expected utility is
2/3 81 + 1/3 36 = 8

The certainty equivalent is given by 𝐶𝐸= 8, i.e. CE = 64. Therefore the maximum
willingness to pay is 81 - 64 = 17.

ii. Now suppose Lee’s risk preference changes so that he becomes risk
neutral, The utility function representing his preference over wealth
levels is given by u(W) = W.
In this case, what is the maximum amount that Lee is willing to pay to
park in a garage? [5 marks]

Expected utility is
2/3(81) + 1/3(36) = 66

The maximum willingness to pay is P such that 81 - P = 66, which implies P = 15.
(b) Rachel has 100 to invest. Two assets, 1 and 2, are available for investment.
An amount y invested in asset 1 yields a total return of 1.1y. An amount x
invested in asset 2 yields a risky total return of x with probability 0.5 and
1.21x with probability 0.5. Rachel’s utility function is given by

U(w) = ln (w)

where w is wealth after investing.

Let any portfolio be denoted by (x, y) where x is the amount invested in
the risky asset (asset 2) and y = 100 − x is the amount invested in the safe
asset (asset 1).
How much should Rachel invest in the risky asset? [10 marks]

Rachel’s expected utility as a function of the amount of investment in the risky asset
(x ) is

This simplifies to

The first order condition for maximisation with respect to x is

This implies

which simplifies to 0.55 = x( 0.011) implying x = 50.