The theory of risk aversion and its utilization by the insurance Essay

The theory of risk aversion and its utilization by the insurance companies - Essay Example This paper outlines the theory of risk aversion, and explains how insurance companies are successfully utilizing this theory to receive substantial amount of profit conducting their activities. Risk aversion is a theory that explains why people are willing to buy insurance. Risk averse means is a situation whereby individuals are willing to pay some money in order to avoid playing a risky game; this takes place even when the expected game value is in this individuals favor. A risk averse individual tends to pay more than the expected value of a game that will let him or her avoid a risk Indemnity is a principle of insurance that states puts it clearly that an insured person will only get compensation if there is a risk occurrence. On the other hand if the event does not occur then the insured will not get any compensation whether money or property. In this case the insurance company will benefit a lot since all the premiums paid will remain as the company’s revenue. The pay off expected by the insured is always less than the premiums he pays; this puts the insurance company in a better position making it a booming business with minimal chances of loss occurrence The big advantage with the insurance company is that it can play games severally and leap much benefits associated with the law of large numbers. The more people the insurance company insures the more it the more it will collect money to cater for administrative costs as well as profits. There is also a numerical illustration in the paper, that helps to bring out the meaning of the theory of risk aversion. The mathematical example makes this theory more intelligible. o the insured it is also obvious that the bigger the pool the smaller the individuals risk of losing large amount of money ,at the same time the less the expected premiums. The Friedman-Savage sought to know why is it that people will buy both insurance and lottery tickets against losses. His view was that this behavior of people was making them both risk averse and risk loving. The answer to this is the fact that a section of the utility function is convex while the other part is concave. Individuals wish to play it safe across the lower range but very much willing to take gambling on the lower and upper parts Illustration A group of thirty people are willing to pay 120 pounds to avoid a risk of losing 15000 pounds. The group can all join together to form a mutual insurance company, collect 120 pounds from each member and pay 15000 pounds to anyone amongst the group who is unlucky and loses coming out ahead. The more people join this mutual insurance company the more the money for its administrative costs and more returns will be realized. By joining this mutual insurance company it shows that the participants are risk averse. The individual's elasticity is . Utility is an indicator of how many percentage points one thing changes as a result of a one percent change in something that affects it.