Intro to Econ: Ninth Lecture Aside – Insurance

We can use the previous posts (one, two, three) on how financial markets deal with risk also to talk about insurance. In fact let us talk about a particular insurance problem. Suppose you live and own a house in Graz, or any other town with a river going through it. I believe Graz has not seen major flooding in a very long time, but with climate change all this could change. Also not having seen flooding in a long time does not mean there is no chance of it happening. And of course many towns in the world have fairly frequent and serious flooding events.

Suppose then that you live in one of these cities and are considering buying insurance against flooding. When I say “against flooding” I, of course, mean that the insurance will pay out some money in the event of a flood and that this amount is so that it covers the costs of all repairs that become necessary because of the damage caused by the flood. Suppose furthermore that there is no other insurance already in place (such as the local or national government paying out some emergency funds in such cases). In this post I want to address the following question: Will you have to pay a large risk-premium on your flood-insurance?

I believe the answer is “probably not”. But the argument behind it comes in two steps. Of course you have to pay at least so much that the insurance company “expects” a non-negative return from giving you insurance. Suppose that according to the assessment of all insurance companies (and they spend a lot of time and care assessing these things) the risk of a flood for your house in one given year is one in ten thousand. Suppose your house is worth half a million Euros. Then you will have to pay at least 500.000 * 1/10.000 = 50 Euros per year for your insurance. The insurance company will certainly not accept anything less. But will they demand a substantial risk premium on top of these 50 Euros? Suppose you are considering getting insurance from a local insurance company that mostly insures people in Graz (or wherever you live). For such a local company, though, the risk of a flooding at your house is probably highly correlated with the risks of flooding of other houses in Graz (even if they may not all have the same risk – depending on how far away in distance and especially altitude your house is from the river). So for such a local insurance company all these risks are highly correlated and, by the argument of one of the previous post, they would probably demand a risk-premium for these risks.

But will they? I don’t think so. Why? Well, there are of course many cities in this world in which there is some flood risk (or other risk). Moreover the risk of flooding in Graz, Austria, is probably not very highly correlated with the risk of flooding in Houston, Texas, or Santiago, Chile, or Canberra, Australia. Does this mean that our local insurance company needs to operate globally, so that they can diversify their risks, as in this post? No. It is in fact quite ok for them to operate locally and offer flood-insurance only in Graz, but buy themselves insurance against the event of a mass-flooding in Graz from a global re-insurance company. This insurance should not demand a risk-premium and this would allow the Graz based insurance company to offer flood-insurance in Graz without a risk premium.

So one would expect that you would get a competitive insurance offer from your local insurance provider (of course you should compare a few and negotiate). The insurance fee will not entail a large risk premium, but will of course (by the usual supply and demand argument) be a bit more than 50 Euros.

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