Question

An enterprising student Oliver decides he can make money by selling grade insurance to his fellow students. Oliver's class has 100 students. He will pay $500 to any student policyholder who gets an F. Because only 2% of all grades are Fs, Oliver computes that he can break even if he charges students a $10 premium. To make a profit, he decides to charge a $15 premium. a) What asymmetric information problem is his business likely to encounter? Explain. b) Would it be helpful to his business if insurance was compulsory for everyone? Explain. c) Would compulsory insurance necessarily make his business profitable? Explain.

Answer 1

A) A kind of assymetric information which the business may suffer is that of students engaging in risk taking behaviour by not studying and this may increase the probability of getting a "F" grade to more than 2%. Since the insurance provider would not be privy to this information, it causes an assymetry and consequently pay out for the insurance company goes up and this may render the business insolvent.

B) Universal coverage would likely help the insurance company as the diversification of risks help in lowering the chances of an adverse event happening and claim being raised. Without that it is possible, that a more risky category opts for insurance and then number of claims increases thus rendering the insurance company insolvent.

C) Compulsory insurance do not guarantee a profitable business. This is because all 100 students may exhibit risky behaviour due to insurance being opted and thus number of claims may increase than the normal value of 2%. This might have an adverse impact on profitability.