Risk and Insurance

Vani Borooah
University of Ulster

Gambles
An action with more than one possible
outcome, such that with each outcome
there is an associated probability of that
outcome occurring. If the outcomes are
good (G) and bad (B), denote the
associated probabilities by pG and pB

Payoffs and Utilities

With each outcome is associated a payoff
which can be expressed in terms of money: $cG
and $cB
With each payoff is associated a utility, u(c):
u(cG) is the utility in the good situation u(cB) is
the utility in the bad situation. We assume that
utility increases with payoff
Note: a payoff is different from the utility from the
payoff

Expected Return and Utility

Expected Return: The expected return
from the gamble is: ER=pGcG+pBcB
Expected Utility: The expected utility
from the gamble is: EU=pGu(cG)+pBu(cB)
Note: The return expected from a gamble
is different from the utility expected from
the gamble

Facing a Gamble
You are faced with a gamble:
If you accept the gamble you will, in
exchange for $W (the amount staked),
receive CG with probability pG and CB with
probability pB
If you reject the gamble you will keep your
$W
You have to decide whether or not to
accept the gamble?

Expected Utility Rule

If you accept the gamble, your expected
utility is EU=pGu(cG)+pBu(cB)
If you reject the gamble, your (certain)
utility is u(W)
The expected utility rule requires you to
compare EU and u(W) and:
accept if EU>u(W)
reject if EU<u(W)
indifferent if EU=u(W)

Certainty Equivalent
How much should the stake be to make
you indifferent between accepting and
rejecting the gamble?
Or what value of W will equate:
U(W) = EU=pGu(cG)+pBu(cB)
Suppose W* solves the above equation
Then W* is known as the certainty
equivalent of the gamble
it expresses the worth of the gamble: $W*

Choice Using Certainty Equivalent

If the certainty equivalent is W* and W is
the stake, you will:
1. Accept the gamble if W < W*
2. Reject the gamble if W > W*
3. Indifferent to the gamble if W = W*

Risk Premium
The risk premium associated with a
gamble is the maximum amount a person
is prepared to pay to avoid the gamble
RP = ER - CE

An Example
Suppose you have to pay $2 to enter a
competition. The prize is $19 and the probability
of winning is 1/3. You have a utility function
u(x)=log x and your current wealth is $10.
What is the certainty equivalent of this
competition?
What is the risk premium?
Should you enter the competition?

Answer:I
1
2
EU log(10 2 19) log(10 2)
3
3
1
2
log(27) log(8)
3
3
1/ 3
2/3
log(27 ) log(8 )
log(3) log(4)
log(12) CE 12
The gamble is worth $12 to him. But, if he rejects the
gamble, he has only $10. So, he will accept the
gamble.

Answer:II
The expected wealth from the lottery is:

1
2
ER (10 2 19) (10 2)
3
3
1
2
1
27 8 14
3
3
3
1
1
So, RP 14 12 2
3
3

Attitudes to Risk
Intuitively, whether someone accepts a
gamble or not depends on his attitude to
risk
Again intuitively, we would accept
adventurous persons to accept gambles
that more cautious persons would reject
To make these concepts more precise we
define three broad attitudes to risk

Three Attitudes to Risk

The Risk Averse Person

The Risk Neutral Person
The Risk Loving Person
To define these attitudes, we use the
concept of a fair gamble
In essence, a fair gamble allows you
receive the same amount of money
through two distinct ways:
Gambling or not gambling

A Fair Gamble
A fair gamble is one in which the sum that
is bet (W) is equal to the expected return:
W = ER = pGcG+pBcB
You are offered a gamble in which you bet
W=$500 and receive:
$250 with pB = 0.5 or $750 with pG= 0.5
ER=$500=W: fair gamble

An Unfair Gamble
An unfair gamble is one in which the sum
that is bet (W) is different (usually less)
from the expected return: W < ER =
pGcG+pBcB
You are offered a gamble in which you bet
W=$500 and receive:
$250 with pB = 0.6 or $750 with pG= 0.4
ER=$450<W: unfair gamble

Attitudes to Risk and Fair Gambles

A risk averse person will never accept a
fair gamble
A risk loving person will always accept a
fair gamble
A risk neutral person will be indifferent
towards a fair gamble

What Does This Mean?

Given the choice between earning the
same amount of money through a gamble
or through certainty
The risk averse person will opt for
certainty
The risk loving person will opt for the
gamble
The risk neutral person will be indifferent

Diminishing Marginal Utility

Why does the risk averse person reject the
fair gamble?
Answer: because her marginal utility of
money diminishes

Example
Your wealth is $10. I toss a coin and offer you $1
if it is heads and take $1 from you if it is tails
This is a fair gamble: 0.511+0.59=10, but you
reject it
Because, your gain in utility from another $1 is
less than your loss in utility from losing $1
Your MU diminishes, you are risk averse
Conversely, if you are risk averse, your MU
diminishes

A risk averse person / with diminishing MU / with a concave utility

function will reject a fair gamble
u(c)
u(750)
u(500)
EU
u(250)

250

400

500

750

The certainty equivalent of the gamble is $400; the risk premium is $100

A risk neutral person / with constant MU / with a linear utility function

will be indifferent between accepting/rejecting a fair gamble
u(c)
u(750)

u(500)
=EU

u(250)

250

400

500

750

The certainty equivalent of the gamble is $500; the risk premium is $0

A risk loving person / with increasing MU / with a convex utility function

will accept a fair gamble
u(c)

u(250)

u(750)
EU
u(500)

250

500 600

750

The certainty equivalent of the gamble is $600; the risk premium is -$100

Contingent Commodities
With contingent commodities, the nature of
the commodity depends upon the
contingency:
A house before a storm is a different good
after a storm
A car before an accident is a different
good after an accident
A holiday in sunshine is a different good
from a holiday during which it rains

Trade in Contingent Markets

The risk of a gamble is the difference between the payoff in
the good state (CG) and that in the bad state (CB): Risk = CGCB
When we buy insurance we try to reduce risk by trading
between two contingent states: good and bad
We do this by buying wealth in the bad state and paying for it
from wealth in the good state
The rate at which we can make this exchange depends on the
premium $ (per $ of insurance bought) charged by the
insurance company
$(1-) of additional CB can be bought by giving up $ of CG
So $1 of additional CB can be bought by giving up (/1-) of
CG

The Insurance Budget Line

Z is amount of insurance
CG = CG- Z < CG
CB =CB- Z + Z =CB + (1-)Z > CB

The slope of the budget

line is -/(1-): as
insurance gets cheaper,
the BL becomes flatter

CG
No Insurance point: Z=0

CG

450 line: CG = CB or full insurance

CB

CB

The Contingent Consumption

Indifference Curves
On each curve, different combinations of CG and CB give
the same level of Expected Utility: pGU(CG) + pBU(CB)
CG

Higher EU on black
curve than on red

CB

Equilibrium in the Insurance

Market
Given the terms offered by the
insurance company, consumer
maximises EU at point A
CG

X: no insurance point
A: equilibrium point

CG
CG*

Z = CB*-CB is amount of
insurance bought
CB CB

CB

Different Types of Equilibrium in

the Insurance Market
Given, the terms offered by the insurance company, consumer maximises
EU at point X or at Y or at some point in between X and Y

CG

X: no insurance equilibrium, Z=0,

insurance too expensive

CG

Y: full insurance equilibrium,

insurance cheap

CG*

CB CG

CB

Condition for Equilibrium

Indifference Curve should be tangential to
budget line
This means that the slope of indifference curve
equals slope of budget line
Slope of indifference curve is marginal rate of
substitution:
how much of wealth in the good state you are
prepared to give up to get another $ of wealth
in the bad state and still be on the same IC
Slope of budget line is rate of exchange:
how much of wealth in the good state you have
to give up to get another $ of wealth in the bad
state

Interpreting Equilibrium
MRSBG = /(1-)

pB
u(CB )

1 pB u(CG ) 1
Note: pG = 1 - pB

An Actuarially Fair Premium

An actuarially fair premium is one which
is equal to the probability of the adverse
contingency: = pB
When the premium is actuarially fair:
u(CB)=u(CG)
So, under diminishing marginal utility:
CB= C G
Implying full insurance

Under what market conditions will an

actuarially fair premium be charged?

The expected profit of an insurance

company is:
Z - pBZ 0
When the insurance industry is
competitive, free entry of new firms will
compete away excess profits:
Z - pBZ = 0
Which implies: = pB