-Steve owns a motorcycle valued at $5,000 and that is his only asset. There is a 5 percent chance that Steve will have an accident within a year. If he does have an accident, his motorcycle is worthless. Steve's utility of wealth curve is shown in the figure above. An insurance company agrees to pay Steve the full value of his motorcycle in case of an accident if he buys the company's insurance policy. The company's operating expenses are $500 per policy. What is the minimum premium that the insurance company will accept?
A) $1,000
B) $2,000
C) $500
D) $1,500

Question

-Steve owns a motorcycle valued at $5,000 and that is his only asset. There is a 5 percent chance that Steve will have an accident within a year. If he does have an accident, his motorcycle is worthless. Steve's utility of wealth curve is shown in the figure above. An insurance company agrees to pay Steve the full value of his motorcycle in case of an accident if he buys the company's insurance policy. The company's operating expenses are $500 per policy. What is the minimum premium that the insurance company will accept?
A) $1,000 
B) $2,000 
C) $500 
D) $1,500

Quizplus · Accepted Answer

The minimum premium the insurance company will accept is the expected loss plus operating expenses. The expected loss is 5% of $5,000, which is $250. Adding the $500 operating expenses, the minimum premium is $750. However, since $750 is not an option, the closest higher option is $1,000.

-Steve Owns a Motorcycle Valued at $5,000 and That Is