Chapter 9

Insurance Approach: Mortality Models and Credit

Risk +
9.1 Introduction to Insurance Approach
Insurance industry works on the principle of rare events. For example, in any given year,
among all the persons an insurance firm insures for accidental death (say), very few, less
than .001% would be unfortunate to have met accidental death. Similarly, of all the
properties insured in a region, during any given year, very few will have it completely
destroyed owing to some natural calamities. Lower still is the probability that more than
3 or 4 properties will get damaged in a year. 1 The simple principle on which Insurance
firms work is simple: For coverage of a particular risk which the risk averse individuals
are willing to avoid, the insurance firms charge a premium. Although the premium
charged by the insurance company is a small fraction of the promised coverage, at any
given time period the insurance company will have to settle more than a few claims are
very low. Therefore, the net profit to the insurance firm is the sum of all collected
premiums (revenue) minus all the payouts (the cost). Therefore, at any given period of
time, some of the important issues for the insurance firm to address are:

What is the chance that one of its clients will have a severe damage

What are the chances that more than one of its policy holders will have severe
damages

What are the chances that a yet undamaged property will not be damaged in the
future.

What is the economic capital to be kept aside in order to pay the claimants in the
event of these damages.

Although a sudden Tsunami, or a Hurricane or an earthquake can cause substantial damage to almost all
the properties in a region. These are typical incidences of highly correlated risks.

9.1.1 The Business of Insurance

Insurance is a form of risk management primarily used to hedge against the risk of
potential financial loss. Insurance is defined as the equitable transfer of the risk of a
potential loss, from one entity to another, in exchange for a premium and duty of care.
The rate of losses although are uncertain, a successful insurance firm should be able to
make some predictions about it. This is important for it to set premiums (prices)
accurately. While insuring a party the insurance firm has to ensure that the potential loss
must be significant ( otherwie, there are no takers) without becoming catastrophic
(otherwise the insurer becomes insolvent ). 2

Typically, an insurance company can insure anything it wants. For diferent types of
insurance, it can either have a conditional contract or a unilateral contract.3 By buying
an insurance, an entity seeking to transfer risk (an individual, corporation, or association
of any type) becomes the 'insured' party once risk is assumed by an 'insurer'. The typical
insurance contract will have two basic features- the premium to be paid (along with its
frequency and duration) and the loss coverage (compensation) promised by the insurer.
Therefore, this legal contract sets out terms and conditions specifying the amount of
coverage (compensation) to be rendered to the insured, by the insurer upon assumption of
risk, in the event of a loss, and all the specific perils covered against (indemnified), for
the term of the contract.
When insured parties experience a loss for a specified peril, the coverage entitles the
policyholder to make a 'claim' against the insurer for the amount of loss as specified by
the policy contract. The fee paid by the insured to the insurer for assuming the risk is
called the 'premium'. Insurance premiums from many clients are used to fund accounts
set aside for later payment of claimsin theory for a relatively few claimantsand for

Although in most countries there are separate Guarantee funds maintained by the State regulators in order
to overcome the problems of insolvency.
3
Property and liability insurance policies are said to be conditional contracts because the obligation of the
insurer to perform may be conditioned upon the insured satisfying certain conditions. In the case of
unilateral contracts, once the premium is paid to the insurer only the insurer can be charged with breach of
contract.

overhead costs. So long as an insurer maintains adequate funds set aside for anticipated
losses, the remaining margin becomes their profit. 4

The profit s of the insurance firm is the sum of Premium s earned and investment income
(revenue) minus the sum of incurred loss from investment and underwriting(or claim
settlement). Thus, insurers make money in two ways - (i) through underwriting, the
process through which insurers select what risks to insure and decide how much premium
to charge for accepting those risks and (ii) by investing the premiums they have collected
from insureds. 5 However, the major function of an insurer is to gather expertise in the
underwriting of polices. Based on a wide assortment of data, insurers predict the
likelihood that a claim will be made against their polices and price products accordingly.
At the end of the policy term, the amount of premium collected minus the amount paid
out in claims is the insurer's underwriting profit. Thisdepends upon how accurately they
can determine the rate structures.

The insurer uses actuarial science to quantify the risk they are willing to assume. Data is
generated to approximate future claims, ordinarily with reasonable accuracy. Actuarial
science uses statistics and probability to analyze the risks associated with the range of
perils covered, and these scientific principles are used by insurers, in conjunction with
additional factors, to determine rate structures. For example, many individuals purchase
homeowner's insurance policies by signing a contract paying a premium to an insurance
company. If a covered loss occurs, the insurer is obliged by the terms of the contract to
honor the insured's claim. For some policyholders, the amount of insurance benefits
received from their insurer will greatly exceed the expense of premiums paid. Others may
never make a claim or receive any benefit other than the peace of mind rendered by the
security of an insurance policy. When averaged, the total claims expense paid by an
insurer should be less than the total premiums paid by their policyholders, with the
difference allocated to overhead and profit.

For some more in depth understanding refer to http://en.wikipedia.org/wiki/Insurance.

One company that is famous for achieving underwriting profit is American International Group. Berkshire
Hathaway, by contrast, is famous for making its money on investments.
5

9.1.2 A Simple Model of How Insurance Works

Suppose you have bought a property whose monetary value , A is Rs 10 million. For
simplicity, let us assume that you plan to sell of the asset after one year. Further, let us
assume that there will be no capital appreciation or depreciation. However, there is an
uncertainty regarding a possible earthquake affecting your area, and you fear the worst
scenario that in the event of the earthquake substantial damage , L (about 80%) will
happen to the property. In other words, the resale value of the property post earthquake
will be Rs 2 million only. However, the chances of this happening is only 0.2%. That is
the probability, p of such a devastating earthquake is equal to 0.002.

What are the possible decisions one can take. One is to do nothing an wait for the
eventuality. Your expected benefit ( or expected utility) in this case is,
EU N = U (W + A) + {pU (W + A L ) + (1 p )U (W + A)} . (9.1)

In the above expression, the first tem is your sure benefits of enjoying the house of
`value, 10 million. We have assumed you have a `free chas flow of W available with
you. The second expression has two terms. The first term, is the discount rate with,

< 1. The second expresson in the curly bracket is your expected benefits of the house.
However, the possible values of the house are 10 million with a probability of 1-

0.00002 = 0.99998 (in the event that the earthquake does not ha ppen), or 2 million with a
probability of 0.00002 if the earthquake does happen. Note that, you being a risk averse
individual, the benefits are U (W + A) rather than A .6 Finally, the superscript `N
indicates the expected payoffs when you do not buy the insurance.
The other option you have is to buy an insurance contract { , P} , where is the premium
(to be paid only today, say) and P is the compensation (or loss coverage) in the event the
earth quake happens. We will assume for simplicity that once a claim is made, the insurer
pays the P no questions asked akin to the unilateral contract.
6

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For risk averse individuals U A is concave. Simply put,

textbook on Microeconomics for details.

U ( A) 0;U ( A) < 0. See any standard

The expected benefits to you in this case will be,

EU I = U ( A + W ) + {pU (W + A L + P ) + (1 p )U (W + A)} (9.2)

By buying the insurance, you have lowered your `liquid wealth by an amount equal to
the premium, . Note that, the expressions in the curly bracket is self explanatory- with
the insurer paying the claimant a compensation amount of P .
It is obvious that you will buy the insurance if and only if, EU I EU N . This implies,
p
[U (W + A L + P ) U (W + A L )] [U (W + A) U (W + A )] (9.3)
1 + (1 p )
The left hand side of the above expression is the expected gains from buying the
insurance in the event of an earthquake while the right hand side is the expected
(negative) benefits of paying the premium today.
How are therefore { , P} set? For this let us turn to the objective function of the insurer.
The expected profits to the insurer is,

E = + { pP} . (9.4)
Note that the insurer collects the premium today and pays out tomorrow an amount P
if the earthquake happens. 7 We are assuming the insurer to be a monopolist. This is just a
simplifying assumption. Therefore, the insurer wishes to maximize his expected profits
subject to the constraint that you will buy the product. In doing so, he will try to
squeeze you as much as possible. This means, for any given P (or ) he will set (or
P ) as high (or low) as possible such that you are just indifferent between buying the

insurance policy or not buying it. In Economics, we call this extracting full consumer
surplus. Note that by doing so he will increase his profits as it is evident from equation
(9.4). What this means is that one can replace the weak inequality in (9.3) by an equality

Insurance firms are assumed to be risk neutral. Therefore there `utility functions are linear.

and solve the problem. 8 We will not attempt to solve the problem now in amore generic
form, instead create a simple example. Interested readers can verify the solution using the
techniques developed in Appendix B.
Let U ( X ) = ln X , where ln X is the natural logarithm of X . 9
Therefore, using this in (9.3) and rewriting it with equality implies,
1+(1 p )

W
+
A
p

P = + (W + A L )
1 (9.5)

W + A

Note that, the coverage has to be more than the premium which is ensured in from above.
Finally, if we substitute this value in (9.4) we will get the expected profits in terms of

only. Once the optimum premium, * is calculated, the same can be used in (9.5) to
get the optimum P* . That will complete the contract.

The solutions to * , P* in our example (with

W = 100,000; A = 10000000, L = 8000000, p = 0.002, = 0.95 ) is (approximately),

* = 8800 and P * = 30,41,700. 10

Although, we will not address this possibility here 11 , the setting up of premium and
compensation, that is the underwriting, is more complicated than indicated here. This is
because of asymmetric information. For example, you may have more information about
the probability of the accident (certainly true with automobile insurance), or post
insurance purchase you may decide to take on more risks- knowing that your insured.
These are the problems of adverse selection and moral hazard respectively. However, we
present another calculation technique employed by the insurance industry- Mortality
Analysis.
8

The problem can be alternately solved using Non Linear Constrained Optimization Techniques (see
Appendix B: Optimization)
9
One can easily verify that U X is concave. In particular, U X is called a constant relative risk
averse utility function.
10
In exercise 9.E.1 we will ask the reader to verify this.

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11

In Chapter XXX we address these issues in details.

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