Page 409 - DECO401_MICROECONOMIC_THEORY_ENGLISH

Microeconomic Theory

Notes Risk Pooling and Risk Spreading

An insurance company takes the risk of his customer’s death with little premium and if he dies, it will
pay a big amount to his family. It can do very simply by collecting the risks of his customer. When an
insurance policy sells the policy then it is not insured a single person but more than thousands people.
It knows that the entire insured person will not die at all except atom war or epidemic. Some persons
can die soon, some in the period of insurance and some will not die after policy matures. So they know
geometrically that the premiums, which they collect from his customers, are more than the payment
given to their customers. In other words, as much as it insured, the ratio of people would low who
actually died annually. It is called Law of Large Numbers. It means as much as the insured person, for
insurance companies, the average result will more forecasted.
Thus, the insurance policy can assume the risk and for profit, it can calculate on the premium amount
collection from customer. Risk pooling, in a large amount of people, can possible only by risk spreading.
It does not only mean that the quantity of insured person should high. It also means that the risk
should independent from the risk covers by all people. Suppose that in a house, an insurance company
insured policy for 100 people. If a big fire comes, then all houses can burnt. The company will get a big
loss. In this condition, the risk of fire is not independent. Now if the similar company insured different
houses then the risk is independent. There is the possibility to burn a single house rather than 100 at a
time because a fire at one home is independent from another home. On the basis of this independent
risk, various insurance companies do not cover war, flood, and earthquake like situations because if it
happens, the risk is very wide.
Another method is diversification by which insurance companies widen their risk. They do various
types of insurance like life insurance, house insurance, car insurance, medical insurance etc. to cover
this.

Insurance is opposite of gambling. It lowers the risk.

Risk Sharing

Risk sharing is another form by which the insurance companies use to cut their cost of risk. The risk
sharing happens when a person insured with a huge amount and if there is an accident, then the claim
would waste to a company. This situation is related to a specific skilled person who insure a part of
his body only. For example, to insure her voice by Lata Mangeshkar or Madonna, an artist from a bad
incident which can stop him to act, etc. Since one person is insured for a big money, the premium is also
huge. If nothing happens to that person, then company will get a huge profit and if anything happens
badly then company will get a big loss.
In this situation, the insurance company opts risk sharing which is also called re-insurance. When
company insures a person’s skill, then by dividing this into sub policies, shares the risk from other
companies. Every company gets a part of premium and the claim is also divided equally if the accident
happens. The big example of risk sharing is the Lioyd’s Insurance Market, London. Thousands of
syndicates and insurance companies are its associate and every syndicate is further divided into 20
associates. Thus, by the risk sharing, a big money is divided and risk gets lower. By dividing the
premiums in syndicates and its associated, if the risk happens, the payment is very low.

Problems of Insurance

There are two main problems which insurance companies face. These are moral hazard and adverse
selection which described as follows—

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