Topic 6- Market Failures related to Managing Risk

What is risk pooling?

Distributing the cost of possible losses over a large number of individuals, transferring risk from an individual to a group.

Example of Risk Pool

Example: 1,000 homeowners each pay $600; if two houses burn down, their losses are paid from that pool.

Purpose of risk pooling

To make risk more predictable

and reduce uncertainty for the insurer.

What is self-insurance?

When a company pays for its own losses instead of buying insurance.

What is captive insurance?

When a company creates its own insurance company to insure itself.

Example of a Captive

Disney forms its own captive insurer because it's large enough to self-cover.

Why do insurance companies exist?

Because individuals cannot easily create or manage their own risk pools, so insurers pool risks for us.

When does the government step in?

The government steps in when risk pools, for insurance companies, aren't grand enough for them to predict loss or can't afford to cover loss. Example: National Flood Insurance Program (NFIP).

What is Variation?

a measure of how much outcomes differ from the average (mean)

What is Standard Deviation?

The square root of variance; shows average spread.

What is Coefficient of Variation (C.V.)?

The ratio of risk to expected value (SD ÷ Mean); the true measure of risk.

Example of Risk for One person. (Includes calculating the risk)

Person A has a 50% chance of $0 loss and 50% chance of $2 loss. Expected value = $1, variance = 1, standard deviation = 1, coefficient of variation (C.V.) = 1. This means high relative uncertainty.

What happens when Person A buys insurance?

Person A transfers risk to insurer by paying $1 premium, but if insurer only insures one person, C.V. = 1 → no benefit from pooling.

Why do insurers sell policies in bulk?

Because selling to one person doesn't reduce risk; large numbers make outcomes predictable.

Example: Adding Person B to the pool

Now the pool is homogeneous. Each has 50% chance of $2 loss. Outcomes: $0, $2, or $4. Expected = $2, variance = 2, SD = 1.41, C.V. = 0.71 → risk reduced 29%.

What is a Homogeneous risk pool?

A group of risks that are similar or identical in nature.

What happens as more people join the pool?

As more similar people join, risk predictability improves. C.V. keeps decreasing but never reaches zero.

Why can't risk reach zero?

Because real-world factors change and predictions rely on moving averages of past data.

Example of Risk Never dropping to zero

Cars with lane assist and automatic braking make accidents less frequent, but insurers must estimate future risks based on changing tech.

What is the Law of Large Numbers?

As the sample size increases, the relative frequency of outcomes gets closer to the theoretical probability of the outcome.

Example of Law of Large Numbers

Insurers don't predict who will get cancer; they predict how many out of 10,000 will, which becomes accurate with large data.

How do insurers collect data?

They use historical data, demographics, driving behavior devices, and algorithms to find patterns.

Example of behavioral data

Auto insurers track speeding, braking, or driving at night to price your risk accurately.

Phone data and ads example

Ads seem like your phone "listens," but it's really algorithms predicting behavior—similar to how insurance predicts losses.

Why is big data valuable?

It improves risk classification, pricing accuracy, profitability, and fairness.

What happens when risks are misclassified?

If pools aren't homogeneous, low-risk people subsidize high-risk ones. Example: everyone paying the same for car insurance would be unfair.

What makes insurance companies good at what they do?

They use statistics, data, and careful risk selection. they also get to get tax write offs early and invest money until they pay claims.

Core function of insurance

A financial device that pools people to share losses and transfer risk. Analogy: reverse lottery—losers (those with losses) get paid.

So the 2 things that insurance involves is.....?

-pooling

-transfer

What is the Income/Wealth transfer in a Risk Pool?

happens when individuals pay premiums to the insurer to protect themselves from potential losses.

Who pays: The people in the pool (policyholders)

Who receives: The insurer, who promises to cover losses if they occur

Effect: Money moves from those who may not experience a loss to those who do experience a loss, spreading the financial impact across the pool.

Why can large employers self-insure?

Because they have thousands of employees and predictable data, unlike individuals. They also have money

What happens if the pool is heterogeneous?

It becomes inefficient and unfair; low-risk people subsidize high-risk ones. Example: flat-rate auto insurance drives safe drivers away.

example 2: everyone's taxes pay for Florida's flood relief

World's largest heterogeneous pool

Social Security—money from workers pays retirees regardless of differences in health or lifespan.

Ideal conditions for pooling

Homogeneous risks, large pool size, reliable data, and correct pricing.

Why is insurance "economically viable risk transfer"?

Pooling makes risk predictable enough that both customer and insurer benefit.

Example of prepackaged insurance

Auto and homeowners insurance—standardized products for predictable risks.

Example of complex insurance

Concert tours or stadiums—require custom underwriting due to less data.

Why do firms and individuals purchase insurance?

Because insurance provides certainty and peace of mind by removing financial worry about unpredictable events. It also allows people and firms to sign contracts that require insurance and protects their assets.

Example of insurance required for a contract

Temple University must have insurance to play football games at Lincoln Financial Field.

Or a restaurant like Saxby's must have insurance to rent space in Alter Hall.

Example of tenant insurance requirement

A landlord often requires tenants to have renter's insurance before signing a lease. It protects the landlord and the tenant's belongings.

How does insurance enhance creditworthiness?

Businesses with insurance are seen as safer investments because they can cover losses. Example: A marijuana dispensary that can get insurance is more likely to get a loan.

What is one type of insurance required by law?

You cannot register a vehicle in any U.S. state without proof of insurance.

What does "certainty/peace of mind" mean in insurance?

You don't know if or when a loss will happen or how severe it will be, but you do know how much it will cost you (the premium). This creates certainty in cost.

Example of certainty in cost

You buy car insurance for $1,500 per year. If you crash and cause $50,000 in damage, you still only pay $1,500 because you already prepaid that loss.

What does a premium represent?

The premium is a known loss — a guaranteed, fixed cost — that provides financial protection and peace of mind.

Does insurance change your actual risk?

No. Buying insurance doesn't make you safer. It only changes financial risk, not the chance of the event itself.

Example of unchanged risk

Buying health insurance doesn't prevent cancer. It only covers the cost if it happens.

What is an insurance policy legally?

A contract between the insured (you) and the insurer (the insurance company) in which the insurer promises to pay for covered losses in exchange for a premium.

Insurance contracts are defined as....? (One word)

Indemnification

Who is the "insured"?

The person or entity buying the policy (you).

Who is the "insurer"?

The insurance company (like State Farm, Progressive, or Allstate).

What is the actual product you get when buying insurance?

A promise — a legal commitment that the insurer will pay for covered losses. Most policies are digital now.

Liability coverage

Insurance that pays for damage or injury you cause to others, not to yourself or your property.

Collision coverage

Insurance that pays for damage to your own vehicle from a crash, regardless of who's at fault.

Full coverage

What people call "full coverage" usually means having both liability and collision insurance, but it still doesn't cover everything (like intentional damage).

What is indemnification?

A legal concept meaning to compensate or reimburse someone for a loss. In insurance, it means putting you back in the same financial position as before the loss.

What does a contract of indemnification mean?

It's an insurance contract promising to reimburse the insured for covered losses, as stated in the policy.

What does "in the event of a covered loss" mean?

The insurer only pays if the loss is listed as covered in the policy. Not all losses are covered.

Full indemnification

When all losses are paid, regardless of size. It means you're returned to your original financial position after the loss.

Are most people fully indemnified?

No. Most have cost-sharing features like deductibles, copays, or partial coverage, so they pay part of the loss.

What is a deductible?

The amount you must pay out of pocket before insurance covers the rest of the loss.

Example of cost sharing: deductible

If your car repair costs $1,700 and your deductible is $250, the insurer pays $1,450. You are not fully indemnified.

What is a copay?

A fixed amount you pay for a service (like $10 for a prescription); the insurer pays the rest.

What is coinsurance?

A percentage of costs you share with the insurer after the deductible (for example, you pay 20%, insurer pays 80%).

When are you fully indemnified?

Usually only in liability cases — when your insurer pays for something you did to someone else.

Key takeaway about indemnification

It puts you back in your original financial position after a covered loss, but you're rarely fully indemnified because of cost-sharing and exclusions.

Why are insurance contracts hard to understand?

They use technical language, include many conditions, and not everyone reads them carefully.

Why do insurance companies collect data?

They need accurate data to predict risk, price policies fairly, and stay profitable.

Example of insurance data in action

State Farm publishes the list of the "most dangerous intersections" in the U.S. using their accident data. In Philadelphia, Roosevelt Boulevard and Red Lion or Grant Avenue are always near the top.

Why is Roosevelt Boulevard dangerous?

It's a highway with red lights, cross-traffic, and houses along it — poor design for its traffic level. Speed cameras were added to reduce accidents.

Who collects and shares this intersection data?

State Farm, the largest auto insurer in the U.S.

Why does State Farm have this data?

Because they insure millions of drivers, so they see accident patterns immediately.

Why do insurers hire meteorologists?

To track storms and predict hurricane or flood risks. Example: Munich Re employs meteorologists to model weather patterns.

Why are insurers considered "green"?

Not for environmental reasons, but for money — they care about accurate pricing and risk, not politics.

How do insurance companies make money if they lose on premiums?

They invest the money collected before it's paid out. Even if they pay out $1.02 per $1 in premiums, investments make up the difference.

Example of investment profit timing

Auto insurance claims are paid out over 1-5 years, so insurers invest premiums during that time to earn profit.

Why must insurance companies be precise with data?

Because their profit margins are small; one mispricing can cause major losses.

What is the main principle of indemnity?

In the event of a loss, your Insurance will never pay you more then what it's worth, aka its 'actual cash value' (ACV)

What is actual cash value (ACV)?

Replacement cost of an item minus depreciation; represents the current value of property at the time of loss.

What is the point of that principle?

To prevent moral hazard (scams)

What is moral hazard?

Behavior changes because an individual is protected by insurance or expects a bailout, leading to riskier actions.

Give an example of moral hazard.

Not buying flood insurance because government may bail out after a hurricane.

What is depreciation?

The reduction in value of an asset over time; affects cars, electronics, and appliances.

Give an example of ACV calculation.

Laptop bought for $899 three years ago; ACV = $400;

What does homeowners insurance cover?

Covers the building for replacement costs; does not cover land; construction costs generally do not depreciate.

What are the main 2 exclusions to the principles of indemnity?

Life insurance

insurance for rare items

How is life insurance value determined?

No ACV; uses a test of reasonableness based on age, income, and expected working years to determine coverage.

What is agreed value or specialty insurance?

Used for rare items like art, collectibles, or classic cars; insured for a pre-determined value.

What tool we use in insurance is based on.....? (2 things)

Frequency and severity

What is the insurance strategy for high frequency and high severity risks?

Avoidance.

What is the insurance strategy for high frequency but low severity risks?

Loss Prevention.

What is the insurance strategy for low frequency and low severity risks?

Retention.

What is the insurance strategy for low frequency but high severity risks?

Insurance.

How do insurers determine if an insurance market is viable?

By comparing gross premium (price) vs maximum price consumers will pay (Pmax); must be financially sustainable.

4 reasons why Pmax> Market Price

-insurance price might be too high because loss is high frequency high severity (example: fires in California)

-the risk charge may be too high because if a lack of data

-if insurance companies were to insure cheap shit, loading cost would be high on the consumer to pay because the companies wouldn't be making a decent profit

-PMax is low (might be a result of moral hazard: like people not buying flood insurance cause of government handouts) (might be result of underestimating risk like in tenants insurance)

Why might flood insurance be expensive or under-purchased?

Costly premiums and moral hazard; government bailouts may discourage individual coverage.

What are the 5 characteristics of an insurable risk? (Just a guideline)

1.Law of Large numbers

2.Adverse selection

3.losses can be determined and measured

4.losses aren't catastrophic

5.Large loss principle

1. One again, what is the law of large numbers?

Bigger sample size, the more accurate your C.O.V is.

Large numbers of similar objects/people allow insurers to predict losses and set premiums accurately.

Why was cyber liability insurance expensive at first?

Initially expensive due to lack of data; became more affordable as data improved and risk charge decreased.

2. What is adverse selection?

When high-risk individuals are grouped with low-risk individuals without proper pricing, causing imbalance in insurance payouts.