Monday, April 13, 2009

Grade Insurance?

Suppose that a company offers "grade insurance" that works as follows: For each course in which you get a grade below a C, the insurance company pays you $500. Before offering the insurance policy for sale, the insurance company looks over the transcripts of university students and finds that on average 10% of all grades are below a C. Explain why the insurance company would be incorrect in assuming that it would only have to pay claims on about 10% of its policies. What is the implication of your analysis for the optimal premium (i.e., price) the company should charge its customers?