Expected Value

| April 22, 2014

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Robert Weed is considering purchasing life insurance. He must pay a $180 premium for a $100,000 life insurance policy. If he dies this year, his beneficiary will receive $100,000. If he does not die this year, the insurance company pays nothing and Robert must consider paying another premium next year. Based on actuarial tables, there is a 0.001 probability that Robert will die this year. If Robert wishes to maximize his Expected Value, he would not buy the policy if the Expected Value were negative for him. He has determined that the Expected Value is, indeed negative for him, but decides to purchase the insurance anyway. Why?
A) He believes that the actual likelihood of his death occurring in the next twelve months is really much greater than the actuarial estimate.
B) While the Expected Value is negative, the utility gained from purchasing the insurance is positive, and high.
C) Mr. Weed is not rational.
D) (a) or (c)
E) none of these
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Construct a decision tree to help analyze this problem. What should the medical professionals do?


Category: Economics

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