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