INSURANCE AND RISK SPREADING

Risk averse individuals want to avoid risks. But risks cannot simply be buried. When a house down, when someone is killed in an automobile accident, or when a hurricane tears through Florida-someone, somewhere, must bear the cost, Markets handle risks by risk spreading. This process takes risks that would be large for one person and spreads them around so that they are but small risks for a large number of people.

The major form of risk spreading is insurance, which is a kind of gambling in reverse, I For example, in buying fire insurance on, a house, homeowners seem to be betting with the insurance company that the house win burn down. H it does DQ. the owner forfeit the charge. If it does burn down, the company must reimburse the owners for the loss at an agreed-upon rate. What is true of fire insurance is equally true of life, accident, automobile, or any kind of insurance.

The insurance company is spreading risks by pooling many different risks: it may insure of houses or lives or cars. The advantage for the 10- assurance’ company is that what is unpredictable for one individual is highly predictable for a population. Say that the Inland Fire Insurance Company insures I million homes, each worth $100,000. The chance that a house will burn down is 1 in 1000 per year. The expected value of losses to Inland is then .001 X $100,000 = $ iOOper house per year. It charges each homeowner $100 plus another $100 for administration and for reserves.

Each homeowner is faced with the choice between the certain loss of $200 for each year or the possible l-in-1000 catastrophic loss of $100,000. Because of risk aversion, the household will choose to buy insurance that costs more than. the expected value of the household’s loss in order to avoid the small chance of a catastrophic loss. Insurance companies can set a premium that will earn the company a profit and at the same time produce .44 expected utility of individuals. Where does the economic gain come from? It arises from the law of diminishing marginal utility, Insurance transfers risks from those who are more risk-averse or who are exposed to disproportionately heavy risks to those who are less risk-averse or those who can more bear risks..Although insurance appears to be just a other form of gambling. it actually has exactly the opposite effect. nature deals us risks, insurance helps reduce .individual risks by spreading them out.

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