Insurance

- Risk averse are willing to pay to keep away from risk.

- If cost of insurance equals expected loss, risk averse people will buy sufficient insurance to totally recover from the potential financial loss

*  While expected wealth is same, the expected utility with the insurance is greater because the marginal utility in event of the loss is greater than if no loss occurs.

*  The purchases of insurance transfers the wealth and increases expected utility.

*  The Law of Large Numbers

- Though single events are random and unpredictable, the average outcome of many identical events can be predicted.

*  Examples

- A single coin toss versus large number of coins

- Whom will have a car wreck versus the number of wrecks for the large group of drivers

*  Assume:

- 10% chance of a $10,000 loss from the home burglary

- Expected loss = .10 x $10,000 = $1,000 having a high risk  

- 100 people face same risk

*  Then:

- $1,000 premium generates a $100,000 fund to cover the losses

- Actuarial Fairness

• When insurance premium = expected payout