Financial Markets by Yale University

Friends, welcome to our website, so today we wanted to talk about... The idea was to talk about insurance and this is a very old idea. In fact, in some sense it is also used by animals, non-human animals. If they share the risk, it's probably some kind of insurance. So it's very basic. And I think you have some idea of ​​what insurance really is, but it does involve some sort of insurance company or government insurance. But policyholders have a contract with the insurance company to protect them against certain well-defined risks and for that they pay a premium, regular payments to the insurance company to be prepared to manage those risks. There is a principle behind insurance and that principle is risk pooling. That is, what is a risk to an individual is not a risk to society at large if they are free. Because by the law of large numbers, the number of bad outcomes is quite predictable. The insurance company pools all of these risks, and is not really risky in itself by the law of large numbers. There is a little mathematical formula for risk pooling which is assuming independent if each, let's say it is a life insurance. If every death is independent of the other, there is no pestilence or war that brings too many deaths at once. Then if you are writing a policy against a single life, the risk you face is the standard deviation given by p(1-p)/n, where p is the probability of death. And you can see that as n gets bigger, the standard deviation approaches zero. The fraction of policies that result in death becomes a practically unknown number. This is the main idea of ​​insurance. According to the law of large numbers, the average of the results obtained from a large number of tests should be closer to the expected value and as more tests are performed, it will get closer. The law of large numbers is important because it guarantees stable long-term results for the average of some random event. So, let's take an example. While a casino may lose money in a single spin of a roulette wheel, its earnings will increase by an estimated percentage on a large number of spins. Thus the casino can confidently pay its monthly bills. Another example would be, if we take a six-sided dice and roll it several times, the average of their values, sometimes called the sample mean, is likely to increase to 3.5 as the accuracy increases as more dice are rolled. Close. Unfortunately, it is not so easy to put this idea into practice, largely due to moral hazard and selection bias.

Moral hazard is when people know they are insured and take on a higher risk. For example, if your home is insured against fire, you might say, "I don't care, I don't care. I will be careless with fire because it is insured." So the risk increases. Or worse, if the insurance company insures your home for more than you think you can sell it, you'll say, "I'll just burn it down and pretend it was an accident. And then stop selling the house to me." Will get more money." Selection bias is different. That is, the insurance company may not be able to see all the risk parameters that define the risk so their customers can see more of them. For example, health insurance attracts sick people. That's why health insurance companies demand medical tests, traditionally, to screen people who know they're already going to get sick. If they are not successful in doing so, then selection bias can harm their business and it can destroy an insurance business because, if people know they are going to get sick, then only sick people can sign up. We do. Insurance must be expensive. Healthy people won't sign up because they don't want to pay the expenses and so the whole thing collapses and doesn't work. So you have to deal with selection bias in the best possible way through examination and disclosure and compulsorily also. The government can make it mandatory that insurance companies do not look at the selection. Obamacare is known for, that health insurance companies are not allowed to take pre-existing conditions into account. Let me give you an example of moral hazard and selection bias in insurance. Today many people in this world are living in marginal economies, subsistence farmers. You have a farm in some very undeveloped part of the world and you depend on the crop every year to feed your family. But unfortunately, the weather throws those curveballs out from time to time. There will be a storm or some kind of drought. So farmers should buy insurance, right? But how do we do that? One type of insurance that has been given for many centuries, I think, is crop insurance. So the farmer buys insurance in case of crop failure. It looks nice and workable. However it has a problem. The problem is that it is subject to manipulation. The farmer can lie about the harvest, right? He might say, "I didn't get much yield this year." That something i. Stealth could close and sell it and then try to claim the insurance.

Or the farmer may be careless. Maybe he's just not that focused guy, okay. that doesn't fix things।It is He gets drunk and doesn't do the necessary work. It is a moral hazard. And then there's selection bias. Farmers who know they are living on marginal land will be the one that will go for insurance. So, crop insurance has been around, but it hasn't worked that well. This leads to an advance that . happened in the last 20 years or so that has been pushed by the World Bank, which is an international development institution. How to insure the weather instead of the crop? Well, because the farmer cannot cheat the weather. He can't make bad weather. We have weather stations. So this sounds like a good idea? Well this is a new idea. Weather insurance for farmers. And it's starting to catch on, especially in the developing world where it's extremely important. For some of these farmers it could be life or death. But then again, does it sound clear and practical? Can you think of any problem related to weather insurance? You have to define weather very carefully if you are going to describe the effect on crops. As a result, if you sow the seeds on a certain date and they begin to germinate, they become vulnerable to drought. A few days after planting and if bad weather comes right, so you have to measure it locally and know when planting took place, details like this to make it work. Along the lines of the moral hazard Jason mentioned, you cited an article that says we are turning financial capitalism more like altruistic capitalism, and my question is, do you think there is a growing trend of philanthropic and non-governmental organizations? Why does the number of people in developing countries have less incentive to insure these natural disasters? Well. This is a complex question. The reason we want insurance as opposed to gifting is because insurance is too logical and out of price so we know exactly what it costs and what you can expect. And so for example, flood insurance in this country was created to prevent people from making a big mistake. The big mistake that was being made was that a lot of people were building houses in the floodplains and you know sometime in the next 20 years, it's going to be a huge flood. And then these people are obviously trusting. "Okay, someone will bail me out." So in the United States of America in 1968, Congress passed a National Flood Insurance Act that specifies that you'd better buy flood insurance and the government would subsidize it but it would have a fair price. So go ahead, build your house in a floodplain but you will have a higher insurance rate. We're going to put a price on it. And that's the idea. So people have already been warned. You better watch as this is a high risk area and flood insurance rates will tell you that. So it is a consistent system. If it's just philanthropy, people will always be... lots of people building on the floodplain. So, you have to pay the price and do the right thing.