Questions and Answers
What concept underlies how insurance manages individual risks within a society?
What role do policyholders play in the insurance process?
Which law explains why insurance companies can predict the number of claims over time?
What is the effect of increasing the number of independent lives covered by life insurance on the standard deviation of death risk?
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What does the mathematical representation for risk pooling specifically calculate?
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Why is the concept of risk pooling fundamental to the operation of insurance?
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What happens to the predictability of outcomes as the number of independent risks increases?
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In insurance theory, what is the implication of a standard deviation approaching zero?
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What is the expected outcome of a casino's earnings over numerous roulette spins?
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What does moral hazard in insurance imply about a policyholder's behavior?
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How can selection bias negatively impact health insurance companies?
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What type of farmers is mentioned as needing crop insurance in marginal economies?
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Which statement best describes a common issue with crop insurance?
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Why might healthy individuals avoid purchasing health insurance in the presence of selection bias?
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What is one of the methods that insurance companies use to manage selection bias?
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What effect can moral hazard have on an insured individual's actions?
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What is a potential result if only sick individuals enroll in a health insurance plan?
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How does the average value from rolling a six-sided dice relate to probability?
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Study Notes
Overview of Insurance
- Insurance is an ancient concept that can even be observed in non-human animals through risk-sharing behaviors.
- Policyholders enter into a contract with an insurance company or government entity to mitigate specific risks.
- Premiums are paid regularly to ensure that the insurance company is prepared to manage potential risks.
Risk Pooling Theory
- Central to insurance is the principle of risk pooling, where individual risks, when pooled together, diminish in overall risk.
- The Law of Large Numbers enables insurance companies to predict outcomes by averaging risks across many policyholders.
- In independent cases (e.g., life insurance), as the number of policies (n) increases, the standard deviation of expected outcomes approaches zero, making risks more predictable.
Importance of the Law of Large Numbers
- Guarantees stable averages over numerous trials, leading to predictable outcomes in insurance.
- Example: A casino expects stable earnings over many roulette spins, despite potential loss in single spins.
- Another example is rolling a six-sided die, where the average result approaches 3.5 with increased rolls.
Challenges in Insurance
- Moral Hazard: Insured individuals may engage in riskier behavior because they feel protected. For example, a homeowner may be careless with fire knowing they have insurance.
- Fraud Risk: Insured value exceeding potential selling price can lead to malicious intent, such as intentionally damaging one's property for profit.
Selection Bias
- Occurs when insurance companies cannot fully assess all risk factors, resulting in attracting higher-risk customers.
- Health insurance often attracts those already sick, leading to financial strain on the company due to increased claims.
- Solutions to mitigate selection bias include mandatory regulations, medical exams, and policy adjustments (e.g., preventing factoring of pre-existing conditions in Obamacare).
Practical Application Example: Crop Insurance
- Subsistence farmers depend on their crop yields for sustenance, making crop insurance beneficial against unpredictable weather.
- However, crop insurance is vulnerable to manipulation, such as farmers falsely reporting low yields to receive insurance payouts.
- This creates a challenge in ensuring genuine claims and maintaining the integrity of insurance systems in marginal economies.
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Description
Explore the fundamental concepts of insurance, its historical significance, and its application beyond humans. This quiz covers basic definitions, types of insurance, and the rationale behind risk-sharing. Test your knowledge on how insurance functions within society.
