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ACTL1001, Week 7

Economics of Risk

Outline:
Risk
Utility, and Expected Utility
Insurance Applications of Expected Utility Theory
Risk Loadings
Time Preference

Reading
(Req) Sherris, Ch 5 (except 5.4)
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Risk
Risk arises from future uncertainty.
Speculative Risk vs Pure Risk
Concerned with Ranking of different risks to decide which risks to take, (or insure
against)
Many different formal definitions of risk - we will define it as future uncertainty
Variability matters!
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Discussion: Risk - Variability matters (?)

Example: You have a choice of investing all your money ($10; 000) in two potential
investments. Which investment would you prefer?
Outcome Probability Investment A Investment B
1
Good 10 50,000 26,000
22
Middle 25 12,500 15,000
1
Bad 50 0 10,000
Analysis:
– Both have Expected Value 16; 000
– A has standard deviation of 11,467.34
– B has standard deviation of 3,405.88
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Utility, Preferences, and Expected Utility

More sophisticated method to allow for risk: (expected) utility
Utility U ( ) used in economics to represent preferences over alternatives.
An individual prefers X to Y (X Y ) if
U (X) > U (Y )
An individual is indifferent between X and Y ( X Y ) if
U (X) = U (Y )
Expected utility allows for uncertain outcomes.
– Uncertainty represented by “states of the world” (n states)
– Usually interested in probability distribution of wealth in different possible outcomes
– Wealth in state i is wi i = 1; 2; : : : n:
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Expected Utility - Definition

Probability wealth will equal wi i = 1; 2; : : : n is
P (W = wi)

i=n
X
P (W = wi) = 1
i=1

0 P (W = wi) 1
Utility wealth W is U (W )
Expected utility representation:
U (W ) = E [ (W )]
Xi=n
= P (W = wi) (wi)
i=1
w
where ( ) is a continuous function.(e.g. e ) (also called a utility function in the
literature)
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Expected Utility: Main Result

Consider X; Y
X is preferred over Y if and only if
U (X) > U (Y )
i.e.
E [u(X)] > E [u(Y )]
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Expected Utility Assumptions

Consider X; Y; Z as risks
Denote % as "Preferred" (note that final outcomes are random)
Assume Preferences are:
– complete: it is assumed that all risks can be compared and ranked
– reflexive: it is assumed that X % X so that any risk is at least as good as the risk
itself
– transitive: it is assumed that if X % Y , and Y % Z then X % Z:
– Independence axiom: states that if X is preferred to Y; then a lottery that pays X
with probability and Z with probability (1 ) will be preferred to a lottery that
pays Y with probability and Z with probability (1 ).
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Exercise
Peter has $1000 wealth. He faces a risk that has a 50% chance of causing him a
loss of $400 dollars. Assume that he makes decisions based on expected utility, with
u (w) = 2w0:5
1. He is offered full insurance for this risk at a premium of $200. Will he purchase this
insurance?
2. He is offered full insurance for this risk at a premium of $300. Will he purchase this
insurance?
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Risk aversion and ()

Preferences exhibit risk aversion when the expectation of a risk is preferred to the
risk
E [W ] W

(E [W ]) > E [v (W )]
2
@ @
Risk aversion implies that the utility function is concave with @w (w) > 0 and @w 2 (w) <
0
If an individual prefers a gamble or risk over the certain amount equal to the expected
value then they are said to be risk lovers.
If an individual is indifferent between the expected value and a gamble or a risk then
they are risk neutral.
@2
Risk preferences exhibit risk neutrality if @w2 (w) = 0
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Commonly used utility functions in actuarial science and finance.

Quadratic utility function
2 1
(w) = w w w<W =
2
Exponential utility function
w
(w) = e >0
0 w
(w) = e >0
00 2
(w) = e w<0
Power utility
w
(w) = 1> >0
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Example: Application to Insurance

Loss of $I will be incurred with probability p.
Amount of insurance (the sum insured) purchased is $I (full insurance)
Insurance premiums a proportion of the amount of insurance equal to I .
Individual has current wealth W:
Compare: Expected utility with and without the insurance
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With full insurance: wealth will be

W I +I I with probability p (a loss event occurs)
W I with probability 1 p (no loss event occurs)
– Expected utility is
pv (W I) + (1 p) v (W I) = u (W I)
No insurance: wealth will be
W I with probability p (a loss event occurs)
W with probability 1 p (no loss event occurs)
– Expected utility is
p (W I) + (1 p) (W )
Prefer to purchase full insurance to no insurance if
(W I) > (p) (W I) + (1 p) (W )
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Optimal Insurance for an Individual

Individual purchases an amount X of insurance where 0 X I:
Wealth distribution will be
W I +X X with probability p (a loss event occurs)
W X with probability 1 p (no loss event occurs)
Expected utility
p (W I +X X) + (1 p) (W X)
Optimal amount of insurance: Differentiate with respect to X and set to zero
0 0
p (1 ) (W I +X X) (1 p) (W X) = 0
(also check second derivative is <0)
Can solve for some specific utility functions.
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Actuarial Premium Principles

Principle of equivalence
– Premium for an insurance contract is determined so that there is equality in
the discounted expected value of the future premiums
the discounted expected value of the loss payments and expenses.
loading for risk - need to either
– adjust probabilities (eg use more conservative assumptions),or
– explicitly load premium (eg add 5%)
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Example: Risk Loading in Premium Calculations

One method to allow for risk loadings in premiums is to use slightly modified proba-
bilities.
Q: Calculating the premium for a term life insurance product with a probability of
claim 0.4. Allowance for risk by increasing the mortality rates used to calculate the
expected value of the loss to 0.5. What happens to the premium in this case?
Assume a sum insured of $1000
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Allowing for risk - Esscher transform

One (amongst many) method of adjusting probabilities is the Esscher transform
– The Esscher transform transforms the probabilities of a random loss X > 0 by
multiplying the original probability density f (x) by
ehX
; h>0
E [ehX ]
Premium is expected value using
ehX
E hX
X
E [e Z ]
1
1 hX
= hX
e Xf (x)dx
E [e ] 0
Esscher premium principle loads the expected value for risk
ehX
E hX
X E [X]
E [e ]
Corresponds to the use of an exponential utility function to allow for insurance risk.
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Example
Suppose h=0.0005. For a random event with probability of claim 0.4, with fixed claim
amount 1000, find the Esscher premium.
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Utility Theory and Time Preference

"Why is time value of money important"
Individual’s choice:
– Current Wealth W
– Consume now or at the end of time period - call C0; C1
– Can Invest for a single time period at an interest rate of r
– Hence "Budget Constraint"
C1 = (W C0) (1 + r)
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Assume total utility f (C0; C1) comes from C0; C1(assumed non random below)
U (C0) + U (C1)
Select current consumption C0 to maximize total utility: Differentiate utility with re-
spect to C0 and equate to zero.
We get:
@U (C1 )
@C1 1
=
@U (C0 )(1 + r)
@C0
– LHS= marginal rate of substitution between future and current consumption.
– RHS= market "exchange rate" (i.e. interest rate) between future and current con-
sumption.
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Determination of Interest Rates

Determined by the marginal utility of additional consumption in the future.
Individuals adjust their current consumption and hence their demand for investment
– until their individual marginal rate of substitution between current and future con-
sumption is equal to the present value of a dollar at the market rate.
The market interest rate is determined by the demand for investment and this reflects
preferences of individuals for future versus current consumption.