Uncertainty

Uncertainty and Insurance

Introduction Uncertainty is major fact of economic life. Uncertainty derives from a number of possible outcomes instead of a single outcome as the consequence of the decision. Individuals exhibit a variety of behavior when faced with choices that involve uncertain outcomes. The first part will discuss individuals’ attitudes towards uncertainty. Generally, people tend to be risk-averse for their preference of a known income rather than uncertainty. They are willing to buy insurance to eliminate or reduce risks. In the second part, the global insurance market will be introduced. As the natural catastrophes are unforeseeable and costly, it is arduous for private sectors to cover these. Hence I believe governments should cooperate with insurers to provide insurance against the natural disasters.

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Attitudes toward Risk: Individuals’ attitudes to risk can be characterized by how a person reacts to what is called a fair gamble, in which the stake is equal to the expected value of the bet. A person who is indifferent about make a fair bet is risk neutral. An individual who is unwilling to make a fair bet is risk averse, while someone who is risk seeking will make a fair bet (Perloff.J.2008).

Figure 1:Individuals’ utility functions

The best excepted utility of the prospect p = (π, y1 , y2 ) on the point c is y   y1  (1   ) y2 . Let f(y) denote the straight line ab at y, we have

f ( y)  v( y1 ) 

[v( y2 )  v( y1 )]( y  y1 ) y2  y1

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Particularly , the height of the line at c above

y   y1  (1   ) y2

is:

f ( y)  v( y1 ) 

[v( y2 )  v( y1 )][ y1  (1   ) y2  y1 ]   v( y1 )  (1   )v( y2 )  v y2  y1

Which gives v as the point c in the figure.

In figure a, the decision-taker is risk-averse since he regards the certainty income as a higher value than its equivalent uncertainty prospect( yc  y ). Hence, risk attraction is equivalent to a strictly concave utility function. By...