Fundamentals of insurance

This section covers the fundamentals of insurance, focusing on risk management concepts and real-world market challenges:

Key Concepts (Risk Pooling & Law of Large Numbers): Insurance is based on the principle of risk pooling, utilizing the Law of Large Numbers, which states that when there are a sufficient number of insured individuals, the overall outcome becomes more stable and predictable, enabling insurance companies to manage risk more effectively.

Major Obstacles to Insurance:

Moral Hazard: Policyholders may engage in riskier behaviors when they know they are insured, such as negligence or fraud.

Selection Bias: This problem arises when high-risk individuals (e.g., those who know they are likely to become ill) choose to purchase insurance more than the general population. This can lead to the failure of the insurance system if selection processes are not adequate.

Case Study: Crop and Weather Insurance:

Traditional crop insurance often suffers from dishonesty or a lack of attentiveness (moral hazard/selection bias).

The World Bank therefore proposes a new alternative: Weather Insurance, which measures performance based on weather stations instead of crop yields. To prevent fraud and increase accuracy:

Insurance vs. Charity: The professor explained that a proper insurance system should calculate the true cost of risk (e.g., flood insurance, which would be much more expensive in high-risk areas) to prevent people from building homes in dangerous areas while relying on government or charitable aid.