Question

Explain the theory of insurance, by specifically addressing the degree of risk aversion, the size of the potential loss, and the "wealth effect".

Answer 1

Ans) The theory of insurance demand is often regarded as the purest example of economic behavior under uncertainty.

- Interestingly, whereas a decade ago most upper-level textbooks on microeconomics barely touched on the topic of uncertainty, much less insurance demand, textbooks today often devote substantial space to the topic.

- The purpose is to present the basic model of insurance demand, that imbeds itself not only into the other papers in this volume and in the insurance literature, but also in many other settings within the finance and economics literatures.

- Since models that deal with nonexpected utility analysis are dealt with elsewhere in this volume, I focus only on the expected-utility framework.

- If we were to view insurance as simply a case of optimal risk sharing, we would be led to a simple sharing rule due to Karl Borch (1962).

- However, for many reasons, not the least of which is the sheer size of the economy, such ideal risk sharing rarely seems to take place. Indeed, even Borch himself had to move from the level of the individual, past the level of the insurance company, and to the level of reinsurance in expositing his classic result. In this sense, we can view insurance as an intermediary.

- Although contingent contracts that allow for mutual risk sharing would be first best, such contracts are not feasible. We thus see insurers in the economy, who approximate the process by gathering and pooling the risks of a large number of individuals.