Saturday, November 27, 2004

Insurance; the basic designs

Reduce it to its simplest form and there are two types of insurance. For simplicity’s sake, let’s look at them in the context of $1.00 life insurance. The first is term insurance; pay me $0.xx, and IF you die in the next year, I’ll pay your heirs $1.00. The second is single-premium whole-life insurance; pay me $0.xx, and WHEN you die, I’ll pay your heirs $1.00. Note that in the first case, I may pay nothing at all; also, the interest earned on the premium, before the insurance term is done, will be negligible. Thus, the insurance pricing will depend entirely on the likelihood that I will need to pay. In the second case, I will pay a benefit; the question is not whether I will pay a benefit, but when I will pay it; the interest earned on the premium may be quite substantial.

Note that in the first case, I’m making only one bet; whether you will die in the next year, or not. In the second, I’m making two; when you will die, and how much interest I will earn in the meantime. These questions will become important as we go on to look at insurance pricing more generally.

In most P&C (Property and Casualty—insurance on things rather than people), the insurance coverages include both the above uncertainties—whether the damage will occur AND when it will occur. Also, the damages (exposures) can vary, rather than being fixed, as they were in the life insurance example.

Next week, we’ll look at varying exposures.


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