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The Financial System

Risk and Insurance


Risk and Insurance

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Now, let's see the relationship between risk and insurance. So let's talk about risk first. So what is the idea of risk? This is being uncertain about the future. And specifically in financial terms were uncertain about future gains or losses were uncertain about things that are gonna happen in the future. So risk occurs because the future is uncertain, right? That's the key thing about risk is that we don't know what's gonna happen in the future. So we might make money, we might lose money, we're not sure. So let's go ahead and do a quick psychological pop quiz here. Which one would you choose? Would you choose that? I just say you can walk away from me right now $0 and just walk away or would you take a gamble and you can receive $1000? We're gonna flip a coin. And if it turns up heads, you get $1000. If it turns up tails, you gotta pay me $1000 would you take that bet? Well, most of you probably just would rather walk away and not take the bet, right? Because the idea here is that you're most likely risk averse, which is a general dislike for risk. You don't like the idea of taking on additional risk because you don't want to lose. What we see is that people generally dislike bad things more than they like good things happening. So they would rather not have a bad thing than have a good thing if they could choose, right? So by just walking away, you're just saying, hey, I don't want to take that extra risk for no reason, right? Because you might have to pay 1000 you might get 1000. And the idea is that the 1000 that you get probably wouldn't give you as much satisfaction as having to pay 1000 would lose you in satisfaction. You're following me that that bad thing is worse than the good thing that could happen. So how do we describe this idea of being risk averse? And I'm sure there's some of you like, hey, I'll take that bet, I'll take that bet. Sorry, I'm not taking that bet. It was just a situational thing. Alright, so how do we quantify this idea? We're gonna use what's called utility. And utility is one of these key words in this class that they love to talk about. And it's basically the economist way of quantifying happiness, right? It's a measure of satisfaction. And I like to think of it as quantifying happiness. So obviously in the real world it's not so easy to think of it like this, but it's like saying, hey, this slice of pizza gives me five utility. I love this pizza. It gives me five utility. How much is five utility? Is that a lot? Is that a little can't really can't really say but we can make some interesting conclusions related to uh satisfaction or happiness based on this one thing we think about is marginal utility. So remember marginal is one of these keywords in economics marginal. Remember we talked about marginal. That's one more. So the additional satisfaction. The marginal utility is gonna be that additional satisfaction from consuming one more unit of a good. Okay, So by consuming one more unit, you're gonna have a little more satisfaction. Now the idea with utility that we've probably talked about in a previous video, but just to remind you is that it follows the law of diminishing returns. Think about a pizza, you're really hungry and you order a pizza and that first slice of pizza, you're like, oh, this is so good. I'm getting like 100 utility, right? That's how you think about it, right? Oh, 100 utility. Then that second slice of pizza, you're like, oh yeah, so hungry. Yeah, 80 utility. It's pretty good. Third slice, 60 utility, uh, I guess I could keep eating 40 utility, right? Each slice gives you less satisfaction in that very first bite of pizza. And that's that idea of diminishing returns, right? That the more you have of something, the less happiness it gets. You think about if you had one car right now, right? You have zero cars, you're broke college student and you have no cars. And all of a sudden you get one car. Whoa, that's awesome. And now someone gives you a second car, you're like, okay, I mean, I had one car, but I'll take two cars. Sure. Yeah, three cars. I mean, why not? You know that first car brings you the most utility, Right? Because you had less of it and you're getting more and more. So this is what our utility graph looks like right here, utility. So we'll have utility on the y axis here and notice what happens here. And this is let's say quantity. Okay. And for our purpose, since we're talking about risk here, let's say the amount of money that you have. Okay, So the amount of satisfaction you get from your first few dollars, you have no money and now you get a little bit of money. Well, you can now buy food, you can buy a house, you can buy your basic needs. So you get a lot of utility out of those first dollars. Right? So now let's say you're somewhere around here and you get a little more money. Let's say for simplicity, let's go right on this line. Right? So you get a little more money and it brings you there, right? What's the extra utility you get? However, what happens if you lost that amount of money? Look how much you would lose a lot more utility. Right? So to make this a little more extreme, let's go ahead and use maybe two pieces of this puzzle of this graph to show you a little more extreme bit there. So let's say that's the marginal utility of gaining a little bit of money. You get a little more satisfaction, right? You already cover your basic needs. now you're able to go on a vacation or something. So you get a little more satisfaction out of that. However, what happens if you lose that amount of money? Well, look how much you're gonna lose here. You're gonna go from here all the way down here. Right, Look at all this lost utility. So this is the gain in utility here from a gain of one unit and this is all the lost utility. Right? So the idea here is that um this is why people are risk averse. They don't want to lose anything because they're gonna lose a lot more than if they gain a little bit, they're not gonna get as much out of it. That's the idea of being risk averse is because losing something hurts you a lot more than gaining something. Okay, and that's what insurance does. It helps us guard against these uncertain losses. So what what people generally insure against is unlikely, Sorry, what's behind me here unlikely. But catastrophic losses like a fire, let me get out of the way unlikely. But catastrophic losses like a fire. Okay, so that's what people generally ensure against. So that's the idea of this right here. So instead of risking all of this loss, let's say this is the loss from a fire loss from fire. Well, maybe someone would be willing to pay this much in insurance, let's say from here to here and be at this level of happiness. So give up a little bit of their satisfaction so that they don't have this risk of losing a lot of satisfaction, right? So they're taking away that big risk by just paying a little bit extra for insurance. And that's the value of insurance is that we take a small risk of paying a little bit of of insurance fees to get rid of the risk of a big loss, like a catastrophic loss from a fire or something like that. Cool, So that's the idea of how risk and insurance are commingled here, and the whole reason why the insurance market exists. Alright, let's take a pause and let's move on to the next video.