Chapter 4 1
Chapter 4 1
Chapter 4 1
• Pooling involves spreading losses incurred by the few over the entire
group, so that in the process, average loss is substituted for actual loss.
• Pooling implies
• The sharing of losses by the entire group
• The prediction of future losses with some accuracy based on the law of large
numbers
2. Basic Characteristics of Insurance
• Example of pooling:
• Two business owners own identical buildings valued at $50,000.
• There is a 10 percent chance each building will be destroyed by a peril in any year.
• Calculate expected value and standard deviation for each owner with pooling and
without pooling.
• Expected return formula: E(X) = Σ[X * P(X)]
• Standard deviation formula: σ = √Σ[(X - E(X))2 * P(X)]
2. Basic Characteristics of Insurance
• No catastrophic loss
• To allow the pooling technique to work
• Exposures to catastrophic loss can be managed by using reinsurance, dispersing
coverage over a large geographic area, or using financial instruments, such as
catastrophe bonds
2. Characteristics of an Ideally Insurable Risk
• Insurance
• Handles an already existing pure risk
• Is always socially productive:
• Both parties have a common interest in the prevention of a loss
• Gambling
• Creates a new speculative risk
• Is not socially productive
• The winner’s gain comes at the expense of the loser
5. Insurance and Hedging
• Insurance
• Risk is transferred by a contract
• Involves the transfer of pure (insurable) risks
• Moral hazard and adverse selection are more severe problems for insurers
• Hedging
• Risk is transferred by a contract
• Involves risks that are typically uninsurable
• Fewer problems of moral hazard and adverse selection for entities who buy or sell futures
contracts
6. Types of Insurance
Insurer A
CFO = -150,000
CF1 : 6 *(- 35,000) + 4 *( -20,000)= -140,000
Þ CF0 = -140,000/1,08= -129,630
CF2 = 4*( -10,000) + 2*(-20,000)+ 2*(-35,000)= -150,000 => -150,000/ 1,08^2= - 128,600
Total expense = -150,000 – 129,630 – 128,600 = -408,230
Ínsurer B
CF0 = -250,000
Cf1 = 6*( - 10,000)+ 4 * (-15,000)= -120,000 => CFO= -120,000/1,08= -111,111
CF2= 4 *( -10,000) + 2*( -20,000) + 2* (-15,000)= -100,000 => CF 0