7 - Risk, Utility, and Insurance

Summary

Learning Objectives

In our day-to-day life, we face many risks. We can get sick or injured. We may get into an accident while we are driving to work. A fire or a flood can damage our houses. If that does not happen, someone may break into our houses and steal our belongings. In addition, we face the risk from not knowing exactly how long we will live. We may live shorter or longer than expected. If the former, our dependents may suffer from lack of financial support. If the latter, we may run out of retirement money. The list goes on. When these unpleasant events happen, their negative effects on our physical and/or financial well-being can be substantial.

Traditionally, there are insurance products that people can buy to manage these risks. In this chapter, we discuss the theoretical foundation of insurance. We look at insurance from both the buyers' and sellers' perspectives. Specifically, we want to determine when insurance should be used and how it is priced. In the process, we formalize the concepts of risks and people's attitudes toward them. The understanding from this chapter will be helpful to our discussion of life insurance in the next chapter.

The Concepts of Risk and Risk Preferences

Definition of Risk

Although there is no single, universally accepted definition of risk, a common one defines it as the variation in possible outcomes of an event that is subject to chance. The greater the variation, the more risky the event is. Risk can be classified into two distinct categories – speculative risk and pure risk.