The year 2005 was marked as the year of the hurricanes as Hurricane Katrina, Rita, and Wilma, all category 5 (wind speeds in excess of 155 mph), devastated the states of Louisiana, Mississippi, Florida, and Texas causing insurers losses worth billions of dollars. Consequently, the private insurers reduced the number of policies they wrote in coastal areas and the premiums skyrocketed. Hence, people often make decision without knowledge of the future, exposing them to risk of loss. Insurance helps, but a market economy is not always the solution to uncertainty. For insurance, for markets to function, two conditions must hold: diversified risk and probability of loss is equally well known to everyone. In the hurricane case both conditions failed. The failure of the second condition involves private information (discussed later).
To delve into the economics of risk, let us first briefly describe a few concepts. A random variable, encountered by people all the time, is a variable that has an uncertain future value. An expected value of a random variable, however, is the weighted average of all states of the world, which is a possible future event. In an instance, when families are faced with random variables, and insurance costs roughly equal the expected values, the families or individuals, take it to reduce risk and uncertainty. This is formally known as risk aversion.
Income has diminishing marginal utility, which means that every additional dollar is worth less than the previous one. With that said, if the family’s utility function has the typical shape of most families, its expected utility-the expected value of its total utility given uncertainty about future outcomes-is less than it would be if the family faced risk. Hence most people would be willing to buy fair insurance (an insurance policy for which the premium is equal to the expected value of the claim). Almost everyone is risk averse because almost everyone has diminishing marginal utility. However there are also individuals who are risk neutral (who are completely insensitive to risk). There are two primary reasons why individuals differ in risk aversion: differences in preferences, and differences in initial income and wealth. This difference is importance because it tells us how much individuals are willing to pay to avoid risk. Risk-averse individuals are willing to make deals that reduce their expected income but also reduce their risk.
The insurance industry rests on two principles. The first is trade in risk and the second is diversification. These are discussed in the chapter as follows.
Trading risk works as people who want to reduce the risk they face pay other people who are less sensitive to risk to take some of their risk away. By varying the premium (plotted on the y-axis) and asking how many insurers would be willing to provide insurance at that premium, we can trace out a supply curve (upward sloping). Meanwhile, potential buyers will consider their willingness to pay a given premium, defining the demand curve (downward sloping). Hence risk markets lead to an efficient allocation of risk (intersection of demand and supply) – an allocation of risk in which those who are most willing to bear risk are those who end up bearing it.
Moving onto the second insurance principle – Diversification. By engaging in diversification-investing in several different things, where the possible losses are independent events (events that are neither more nor less likely to happen if the other one happens) -individuals could make some of the risk disappear. For instance, in the modern economy, diversification is much easier for investors by the fact that they can easily buy shares in many companies by using the stock market. In some cases, an investor can make risk almost entirely disappear by taking a small share of the risk in many independent events. This is known as pooling. When an insurance company is able to take advantage of the predictability that comes from aggregating a large number of independent events, it is said to engage in pooling of risks.
However, diversification has its limits. There are many positively correlated (each event is more likely to occur if the other event also occurs) financial risks that investors face today: Within any given region in the US, losses due to weather are definitely not independent events, political event (war, or a revolution) can damage business around the globe and in the case of business cycles, one company’s downfall due to recession, affects other companies as well again making such an even positively co-related. When the events are positively co-related, the risks they pose cannot be diversified.
Markets fail when there exists private information (some people know things that other people don’t know). It is a problem because of the following.
Adverse selection: It occurs when an individual knows more about the way things are than other people do. In private information buyers expect the sellers to hide defects in things available for sale, which leads to low prices and hence the superior items are kept away from the market. However, adverse selection could be countered through screening: using observable information about people to make inferences about their private information. Signaling is another way to prevent adverse selection. In signaling people use actions to demonstrate what they know. Similarly, a good reputation also counters adverse selection by suggesting that the seller has that reputation in the first place due to a trustworthy historical record of selling items.
When people know more about their actions that other people, it is categorized as a Moral Hazard. Hence people fail to appropriately look after their belongings when they know somebody else (the insurance company) would bear the price of the lack of care. Insurance companies, hence, tackle with moral hazard through deductibles: Insurance companies only reimburse for losses above a particular amount, so that the coverage is always less than 100%.