Your employer, an insurance company, would like to offer theft insurance for renters. The policy would pay the full replacement value of any items that were stolen from the apartment. Some apartments have security alarms installed. Such systems detect a break-in and ring an alarm within the apartment. The insurance company estimates that the probability of a theft in a year is .05 if there is no security system and .01 if there is a security system (there cannot be more than one theft in any year). An apartment with a security system costs the renter an additional $50 per year. Assume that: the dollar loss from a theft is $10,000, the insurance company is risk neutral, and the renter would be willing to pay more than the expected loss to insure against the loss of theft. What is the insurance company's break-even price for a one-year theft insurance policy for an apartment without a security system? Does a renter have an incentive to pay for a security system if he does not have insurance? To answer this question you must calculate the expected cost to the renter with and without a security system. For a security system to be effective the renter must turn it on whenever he or she leaves the apartment. Suppose it costs the renter $10 per year in expended effort to turn on the alarm system. What is the insurance company's break-even price for a one year theft insurance policy for an apartment with a security system? (HINT: Moral Hazard) What deductible amount would provide sufficient incentive for the renter to turn on the alarm system each time he or she leaves the apartment? What is the insurance company's break-even price for a one year theft insurance policy with that deductible amount for an apartment with a security system?

Managerial Economics: A Problem Solving Approach

5th Edition

ISBN:9781337106665

Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor

Publisher:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor

Chapter17: Making Decisions With Uncertainty

Section: Chapter Questions

Problem 7MC

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Your employer, an insurance company, would like to offer theft insurance for renters. The policy would pay the full replacement value of any items that were stolen from the apartment. Some apartments have security alarms installed. Such systems detect a break-in and ring an alarm within the apartment. The insurance company estimates that the probability of a theft in a year is .05 if there is no security system and .01 if there is a security system (there cannot be more than one theft in any year). An apartment with a security system costs the renter an additional $50 per year. Assume that:

the dollar loss from a theft is $10,000,
the insurance company is risk neutral, and
the renter would be willing to pay more than the expected loss to insure against the loss of theft.

What is the insurance company's break-even price for a one-year theft insurance policy for an apartment without a security system?
Does a renter have an incentive to pay for a security system if he does not have insurance? To answer this question you must calculate the expected cost to the renter with and without a security system.
For a security system to be effective the renter must turn it on whenever he or she leaves the apartment. Suppose it costs the renter $10 per year in expended effort to turn on the alarm system. What is the insurance company's break-even price for a one year theft insurance policy for an apartment with a security system? (HINT: Moral Hazard)
What deductible amount would provide sufficient incentive for the renter to turn on the alarm system each time he or she leaves the apartment?
What is the insurance company's break-even price for a one year theft insurance policy with that deductible amount for an apartment with a security system?

Please answer questions 3-5

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