In this chapter, the following content will be discussed: Private insurance institutions were invented after fire of London 1666, role of discovery of probability theory in this invention, the extension through time of insurance practice into increasingly more realms of human risk, modern insurance companies and their regulators. | Lecture 4: Insurance The Archetypal Risk Management Institution Fundamental Insurance Principles and Issues Risk Pooling is the source of all value in insurance Moral Hazard dealt with partially by deductions and co-insurance Selection bias dealt with by group policies, by testing and referrals, and by mandatory government insurance Risk Pooling If n policies, each has independent probability p of a claim, then the number of claims follows the binomial distribution. The standard deviation of the fraction of policies that result in a claim is Law of large numbers: as n gets large, standard deviation approaches zero. Aristotle on Probability “To succeed in many things, or many times, is difficult; for instance, to repeat the same throw ten thousand times with the dice would be impossible, whereas to make it once or twice is comparatively easy.” (De Caelo) Earliest Known Description of Insurance Idea Anonymous letter to Count Oldenberg, 1609, proposes that people pay 1% of value of home into a fund, to be used to replace house after fire. Writer says he(she) “had no doubt that it would be fully proved, if a calculation were made of the number of houses consumed by fire, within a certain space, in the course of thirty years, that the loss would not amount, by a good deal, to the sum that would be collected in that time. Insurance as an Invention Contract design, specifying risks, excluding risks subject to moral hazard or selection bias. Definition of loss and sufficient proof of loss Mathematical model of risk pooling Collection of statistics on risks, and evaluation of the quality of such statistics. Corporate or mutual form for the company Government verification of insurance company’s ability to pay Government regulation of insurance Invention of Insurance In ancient Rome, burial societies and bottomry. (Burial insurance still a factor in less developed countries.) Actuarial science developed in late 1600s Modern fire insurance began in London, insurance gradually | Lecture 4: Insurance The Archetypal Risk Management Institution Fundamental Insurance Principles and Issues Risk Pooling is the source of all value in insurance Moral Hazard dealt with partially by deductions and co-insurance Selection bias dealt with by group policies, by testing and referrals, and by mandatory government insurance Risk Pooling If n policies, each has independent probability p of a claim, then the number of claims follows the binomial distribution. The standard deviation of the fraction of policies that result in a claim is Law of large numbers: as n gets large, standard deviation approaches zero. Aristotle on Probability “To succeed in many things, or many times, is difficult; for instance, to repeat the same throw ten thousand times with the dice would be impossible, whereas to make it once or twice is comparatively easy.” (De Caelo) Earliest Known Description of Insurance Idea Anonymous letter to Count Oldenberg, 1609, proposes that people pay 1% of value of home
