Thursday, November 20, 2008

The Importance of Insurance

We are at the point in my data analysis class where I am teaching students how to calculate insurance premiums. The example we are using in class is yield insurance, where farmers get paid money if their crops experience low yields. Using the methods outlined in these notes, I teach them how insurance companies decide how much to charge.

Insurance markets are becoming increasingly important. Weatherproof is a company that makes coats, and people buy more coats when the weather is cold. If winters are increasingly warm, they stand to lose lots of money. To protect against this loss, they purchased an insurance policy that pays out $10 million in the month of December if the average daily temperature exceeds 40 degrees. Read more.

My father used to make money by putting on rodeos. He would pay a rodeo contractor to put on the show, and my father sold tickets to the show. If the weather was bad and people didn't show up to purchase tickets, he still had to pay the contractor. If he was still in the rodeo business, he could protect himself about bad weather by purchasing a customized weather insurance policy from CSI Entertainment Insurance.

Thriving insurance markets are important for society as a whole. Without affordable home insurance, one accident could plunge a normal family into financial ruin. I need not describe the importance of health insurance. For insurance markets to thrive, we must have people who can understand the economics of insurance and the basic of statistics to calculate what premiums they should charge. It is important for both insurance companies and societies. That is why we subsidize students to learn statistics and economics!
One of the reasons our economy is sick is that AIG (American International Group) started selling insurance on home mortgages. If you own home mortgages as part of your investment portfolio, you run the risk that some of those homeowners will default. AIG sold people insurance that pays out in the case default does occur. Yet they didn't crunch the numbers correctly. They underestimated the probability of a home default, and as a consequence, ran their company and our economy into the ground. (more on AIG here)

Note: an interesting NY Times article on the importance of weather forcasting in fashion can be found here.

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