Welcome back so far we have examined four out of the seven different categories of financial intermediaries in this lecture we’ll take a step forward and delve into the fifth one all right people say that insurance is what nobody wants but everybody needs the concept has been in existence for centuries dating back to the second and third century bc when merchants paid an
Extra fee to shipping companies for the reimbursement of their cargo in the event it got lost on the way contrary to popular belief this financial product hasn’t changed much since then at present we define insurance as a contract in which individuals or companies receive financial protection against losses from another firm in return the insured agrees to pay a premium the cost of the contract
For the coverage they receive put simply insurance contracts transfer risk from the ones who buy them to those who sell them common examples are auto life fire or medical agreements most people in the united states have at least one of these types while car insurance is required by law at this point you must be wondering how can insurance companies possibly manage so many types of risks
At the same time the answer lies in the portfolio approach to investing i’m sure you still remember the saying don’t put all of your eggs in one basket if we invest our capital in a single security and it fails we lose all our money at once on the opposite if we diversify our funds by holding multiple assets our portfolio will continue to be safe even if one of them crashes similarly insurers protect a diversified pool of
Policyholders whose profiles and risks of losses are typically uncorrelated this presupposes more predictable cash flows compared to a single insurance contract like any other economic activity insurance industry has to deal with a number of challenges let’s consider some of them to begin with moral hazard is a difficulty for all
Insurers it occurs when the insured is ready to take more risks than necessary because they know that they have protection against the possible losses adverse selection on the other hand takes place when those who are most likely to experience losses are the ones buying insurance contracts that’s where exclusions come in handy another critical aspect the insurance business encounters
Is fraud this is when someone deliberately causes damage or report a fictitious loss trying to collect on insurance it’s under close scrutiny at all times all these external risks put insurers in a difficult situation and require carefully designed underwriting policies in order to avoid any subjectivity matters this brings us to the end of our discussion you did great
