Financial Markets and Institutions (2-downloads)

513

21

C H A P T E R

---

514

Part 6 The Financial Institutions Industry

Insurance Companies

Insurance companies are in the business of assuming risk on behalf of their customers

in exchange for a fee, called a premium. Insurance companies make a profit by

charging premiums that are sufficient to pay the expected claims to the company plus

a profit. Why do people pay for insurance when they know that over the lifetime of

their policy, they will probably pay more in premiums than the expected amount of

any loss they will suffer? Because most people are risk-averse: They would rather pay

a certainty equivalent (the insurance premium) than accept the gamble that they

will lose their house or their car. Thus, it is because people are risk-averse that they

prefer to buy insurance and know with certainty what their wealth will be (their

current wealth minus the insurance premium) than to incur the risk and run the

chance that their wealth may fall.

Consider how people’s lives would change if insurance were not available.

Instead of knowing that the insurance company would help if an emergency

occurred, everyone would have to set aside reserves. These reserves could not be

invested long-term but would have to be kept in an extremely liquid form.

Furthermore, people would be constantly worried that their reserves would be

inadequate to pay for catastrophic events such as the loss of their house to fire,

the theft of their car, or the death of the family breadwinner. Insurance allows

us the peace of mind that a single event can have only a limited financial impact

on our lives.

0.5

1.0

1.5

2.0

2.5

1995

1990

1985

1980

1975

1970

1965

1960

Millions

of Persons

2000

2005

F I G U R E   2 1 . 1

Number of Persons Employed in the U.S. Insurance Industry,

1960–2008

Source: Life Insurance Fact Book, 2009 (American Council of Life Insurers);

http://www.acli.com/ACLI/Tools/Industry+Facts/Life+Insurers+Fact+Book/GR09-+215.htm

.

---

Chapter 21 Insurance Companies and Pension Funds

515

Fundamentals of Insurance

Although there are many types of insurance and insurance companies, all insurance

is subject to several basic principles.

1. There must be a relationship between the insured (the party covered by insur-

ance) and the beneficiary (the party who receives the payment should a loss

occur). In addition, the beneficiary must be someone who may suffer potential

harm. For example, you could not take out a policy on your neighbor’s teenage

driver because you are unlikely to suffer harm if the teenager gets into an acci-

dent. The reason for this rule is that insurance companies do not want peo-

ple to buy policies as a way of gambling. We will discuss how credit default

swaps violate this rule later.