Yesterday, we discussed three particularly important insurance economics concepts: 1) the Bernoulli Principle, 2) the Mossin Theorem, and 3) the Arrow Theorem. The Bernoulli Principle implies that if an actuarially fair full coverage insurance policy is offered, then an arbitrarily risk averse individual will purchase it. The Mossin Theorem implies that if insurance is actuarially unfair, then an arbitrarily risk averse individual will prefer partial insurance coverage over full insurance coverage. Finally, the Arrow Theorem implies an arbitrarily risk averse individual will select deductible insurance from the menu of partial insurance choices that were considered during class yesterday.
In what follows, I present a recap of the analytic and numerical proofs of the Bernoulli Principle and Mossin Theorem which took up most of our attention in class yesterday.
The Bernoulli Principle is graphically illustrated in the following figure (taken from p. 4 in the Insurance Economics lecture note):
Here, the consumer has initial wealth of $120 and there is a 25% chance that a fire will occur which (in the absence of insurance) will reduce her wealth from $120 to $20. The expected loss is E(L) = .25(100) = $25, which is the actuarially fair price for a full coverage insurance policy. Thus if she remained uninsured, she would have E(W) = .25(20) + .75(120) = $95, and her utility would be EU. Note that the (95, EU) wealth/utility pair corresponds to point C in the figure above. Now suppose the consumer purchases an actuarially fair full coverage insurance policy. Since she is fully insured, she is no longer exposed to any risk; her net worth is $95 irrespective of whether the loss occurs, her utility is U(95), and her wealth/utility pair is located at point D in the figure above. Since U(95) > EU, she will fully insure. More generally, since this decision is optimal for an arbitrarily risk averse consumer, it is also optimal for all risk averse consumers, irrespective of the degree to which they are risk averse.
Next, we introduced coinsurance. A coinsurance contract calls for proportional risk sharing between the consumer and the insurer. The consumer selects a coinsurance rate , where represents the proportion of loss covered by the insurer. By definition, is bounded from below at 0 and from above at 1. Thus, if the consumer selects = 0, this means that she does not purchase any insurance (i.e., she self-insures). If she selects = 1, this implies that she obtains full coverage. Furthermore, the price of a coinsurance contract is equal to the price of a full coverage insurance contract (P) multiplied by . On pp. 6-7 of the Insurance Economics lecture note, I analytically (via the calculus) confirm the Bernoulli principle by showing that if the consumer’s utility is U = W^{.5 }and insurance is actuarially fair, then the value for which maximizes expected utility is = 1. An Excel spreadsheet called the “Bernoulli and Mossin Spreadsheet” is available from the course website which enables students to work this same problem using Solver. I recommend that you download this spreadsheet and use Solver in order to validate the results for a premium loading percentage (β) equal to 0 (which implies a full coverage (actuarially fair) premium P = E(L)(1+β) =$25 x (1+0) = $25) and β = 0.6 (which implies an actuarially unfair premium of $40, the analytic solution for which is presented on p. 8 in the Insurance Economics lecture note).
Let’s use Solver to determine what the optimal coinsurance rate () is for U = W^{.5 }when β = 0 (i.e., when insurance is actuarially fair and full coverage can be purchased for the actuarially fair premium of $25). To do this, open up the Bernoulli and Mossin Spreadsheet and invoke Solver by selecting “Data – Solver”; here’s how your screen will look at this point:
This spreadsheet is based upon the so-called “power utility” function U = W^{n}, where is 0 < n < 1. Since we are interested in determining the optimal coinsurance rate for a consumer with U = W^{.5}, we set cell B2 (labeled “exponent value”) equal to 0.500. With no insurance coverage (i.e., when = 0) , we find that E(W) = $95 and E(U(W)) = 9.334. Furthermore, the standard deviation (σ) of wealth is $43.30. This makes sense since the only source of risk in the model is the risk related to the potentially insurable loss.
Since we are interested in finding the value for which maximizes E(U(W)), Solver’s “Set Objective” field must be set to cell B1 (which is a cell in which the calculated value for E(U(W)) gets stored) and Solver’s “By Changing Variable Cells” field must be set to cell B3 (which is the cell in which the coinsurance rate gets stored). Since insurance is actuarially fair (β = 0 in cell B4), the Bernoulli Principle implies that the optimal value for is 1.0. You can confirm this by clicking on Solver’s “Solve” button:
Not only is = 1.0, but we also find that E(W) = $95, σ = 0 and E(U(W)) = 9.75. Utility is higher because this risk averse individual receives the same expected value of wealth as before ($95) without having to bear any risk (since σ = 0 when = 1.0).
Next, let’s determine what the optimal coinsurance rate () is for U = W^{.5} when β = 0.60 (i.e., when insurance is actuarially unfair). As noted earlier, this implies that the insurance premium for a full coverage policy is $25(1.60) = $40. Furthermore, the insurance premium for partial coverage is $ 40. Reset ’s value in cell B3 back to 0, β’s value in cell B4 equal to 0.60, and invoke Solver once again:
On p. 8 in the Insurance Economics lecture note, we showed analytically that the optimal coinsurance rate is 1/7, and this value for is indicated by clicking on the “Solve” button:
Since = 1/7, this implies that the insurance premium is (1/7)40 = $5.71 and the uninsured loss in the Fire state is (6/7)(100) = $85.71. Thus in the Fire state, state-contingent wealth is equal to initial wealth of $120 minus $5.71 for the insurance premium minus for $85.71 for the uninsured loss, or $28.57, and in the No Fire state, state-contingent wealth is equal to initial wealth of $120 minus $5.71 for the insurance premium, or $114.29. Since insurance has become very expensive, this diminishes the benefit of insurance in a utility sense, so in this case, only a very limited amount of coverage is demanded. Note that E(U(W)) = 9.354 compared with E(U(W)) = 9.334 if no insurance is purchased (as an exercise, try increasing β to 100%; you’ll find in that case that no insurance is demanded (i.e., = 0).
I highly recommend that students conduct sensitivity analysis by making the consumer poorer or richer (by reducing or increasing cell B5 from its initial value of 120) and more or less risk averse (by lowering or increasing cell B2 from its initial value of 0.500). Other obvious candidates for sensitivity analysis include changing the probability of Fire (note: I have coded the spreadsheet so that any changes in the probability of Fire are also automatically reflected by corresponding changes in the probability of No Fire) as well as experimenting with changes in loss severity (by changing cell C8).