Economics of Insurance

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Economics of Insurance
Some important notes.
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4 Topics.
Utility Functions
Calculating Ceftainty Equivalents
Insurable Risks
An Alternative View.
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Utility Functions.
Utility with respect to asset values is the key
to taking decisions about risky options
We have used two type of function
Where a is between 0 and 1
U Xa
U log X
Both are RISK AVERSE functions.
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We need to be able to work out the CERTAINTY
equivalent of a risky prospect
This will give us the MAXIMUM premium an
individual will pay to insure against a bad event
It will also give the maximum PREMIUM RATE an
individual will find acceptable
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For a risk to be insurable it must be
profitable to insure
poolable
no moral hazard
measurable
low probability
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KAhneman and Tversky
Want nto replace utioity maximising hypothesis
with
BEHAVIOURAL theories of choice
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They think that people behave
In CONTEXT they have a frame or norm from which
they make judgements
Tend to favour the STATUS QUO
Are LOSS averters, not simple risk averters
Have a LOSS FUNCTION
Consciously or mistakenly misestimate
probabilities
Have a probability weighting function
Loss function is CONCAVE from below.