RISK AND INSURANCE

People seek security. A sense of security may be the next basic goal after food, clothing, and shelter. An individual with economic security is fairly certain that he can satisfy his needs (food, shelter, medical care, and so on) in the present and in the future. Economic risk (which we will refer to simply as risk) is the possibility of losing economic security. Most economic risk derives from variation from the expected outcome.

One measure of risk, used in this study note, is the standard deviation of the possible outcomes. As an example, consider the cost of a car accident for two different cars, a Porsche and a Toyota. In the event of an accident the expected value of repairs for both cars is 2500. However, the standard deviation for the Porsche is 1000 and the standard deviation for the Toyota is 400. If the cost of repairs is normally distributed, then the probability that the repairs will cost more than 3000 is 31% for the Porsche but only 11% for the Toyota.

Modern society provides many examples of risk. A homeowner faces a large potential for variation associated with the possibility of economic loss caused by a house fire. A driver faces a potential economic loss if his car is damaged. A larger possible economic risk exists with respect to potential damages a driver might have to pay if he injures a third party in a car accident for which he is responsible.