Personal Financial
Management
Semester 2 2008 – 2009
Gareth Myles g.d.myles@ex.ac.uk
Paul Collier p.a.collier@ex.ac.uk
Reading
Callaghan: Chapter 9
 McRae: Chapter 7

Insurance

The lectures so far have been about
generating and managing wealth
 Insurance can be seen as the protection of
wealth
 Insurance



The pooling of risks between a group of individuals
A potentially large loss can be covered for a small
price
The premium purchases a policy to provide
cover against carefully defined losses
Principles of Insurance

Example 1

Assume
(1) A 1 in 1000 chance of a house fire
 (2) Each house is worth £100,000
 (3) A community of 1000 houses

1 house per year will be lost on average
 The potential losses can be covered for
£100 per year if all purchase insurance
 Issues that may arise?

Principles of Insurance

Example 2
It is also possible to interpret some
investment activities as insurance
 A put option is the right to sell at a fixed
price

You hold a share and wish to avoid a loss if its
price falls
 Buy a put option which can be exercised if the
share price falls

When to Insure?

McRae provides the following table
providing advice on when to insure
Frequent
Infrequent
Small
Loss
Modify
Self insure
behaviour
Large
Loss
Change
Insure
behaviour
Forms of Insurance

The most common forms of insurance
are:

Home/contents insurance
cost of premium: sum insured, location (crime,
flooding, subsidence)
 Direct Line


Life insurance
Premium depends on sum insured
 Characteristics of person (health, behaviour,
history)
 Life Predictor

Forms of Insurance

Car insurance

Cars are in categories 1 – 20 based on
performance, repair cost and susceptibility to
theft






Group 1: Citroen C2 1.1, Fiat Seicento 1.1
Group 6: Ford Focus 1.8, Peugot 2.0 HDi
Group 14: Mitsubishi Shogun Sport, BMW 318 Ci
Group 17: Honda Civic Type R, Seat Leon Cupra
Group 19: Nissan 350Z
Group 20: Corvette, Mitsubishi Evo FQ360
Forms of Insurance

Basic premium is then adjusted for




Characteristics of driver: age, experience, occupation,
no-claims bonus
Form of use
Location
Parking
Quotes can be obtained on-line
Car insurance
 Compared to home insurance the characteristics
of the party insured are much more important

Forms of Insurance

Extended Product Warranties
Insure a product against failure or need for
repair
 Usually sold with electrical items
 Typically appear very costly – but need to do
some analysis to assess this
 Product Warranty

Economics of Insurance

Consider a population of size n each with
asset worth Y
 Let p be probability of total loss
 Total loss each year is pnY
 If this loss is shared equally across the
population, a fair premium is
p = pY

This premium is actuarially fair and a
population-wide insurance plan would break
even
Is Insurance Fair?

Television






The television costs £659.95
The premium is £499.99 for 2 years
This is fair for a 72% chance of total failure in this 2
year period
Is failure rate this high?
Other product warranties can be even higher
Other forms of insurance


House, life: clear probabilities, competitive
Car: probability of very high loss events
Why Insure?

Would you buy insurance?
Y-p
insurance
choice
no insurance

p
1–p
0
Y
Let utility of wealth be U(W)
U(Y – p)

Choice then compares:
(Expected Utility Theorem)
pU(0) + (1 – p)U(Y)
Choice
Utility
U(Y)
U(Y - p)
pU(0) + (1 - p)U(Y – p)
U(0)
45o
0
Y-p Y
Wealth
Shape of utility: decreasing marginal utility of wealth
Insurance Issues

Moral Hazard
Behaviour can change once insured
 Full insurance may not be possible


Adverse Selection
Bad risks will be attracted to insurance
intended for good risks
 This can force good risks out of market
