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Lecture 16 - Insurance Institutions

Lecture 16 - Insurance Institutions - Loss Financing...

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Loss Financing through Insurance Insurance purchase: Customer (“policyholder”) pays insurer a fixed payment (“premium”) for an insurance policy The insurer promises to pay losses that the customer incurs from the insured risk (“claims”) The insured risk exposure and terms of payment are carefully defined in a contract (insurance “policy”)
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Insurance as Risk Pooling The insurer pools risk across many (similar) individuals by selling many policies The insurer faces less uncertainty about average losses (per person) than does each insured individual Uncertainty is lower when the number of policies is larger
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Risk Pooling Expected claim cost = $100 per policyholder Actual claim costs per policyholder are uncertain Probability distribution of average claims is approximately Normal and centered around $100 Avg claims $100
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Why Insurance Companies? Insurers are intermediaries that lower the cost of pooling arrangements Estimate loss distributions Identify pool members Verify and process claims Insurers are also residual risk bearers Policyholders pay a fixed insurance premium Insurer bears risk that losses exceed expected value
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Fixed Premiums Why do insurers charge a fixed premium instead of assessing policyholders for losses after the fact?
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