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Chapter 11: Problem 22

How do insurance companies use expected value to determine what to charge for a policy?

Short Answer

Expert verified
Insurance companies use the expected value concept from statistics to determine policy prices. They calculate the expected losses they may have to cover, based on all potential scenarios and their probabilities. The calculated premium aims to cover this expected loss, operational costs, and company profit, including an extra 'risk premium'. Hence, customers with higher expected losses due to higher risks are usually charged higher insurance premiums.

Step by step solution

01

Understanding the Concept of Expected Value

Expected value (EV) is a fundamental concept in probability and statistics. It refers to the average outcome that one can expect over a large number of trials. The formula for expected value is given by multiplying each outcome by its probability of occurrence, and then summing these values.
02

Role of 'Expected Value' in Insurance

Insurance companies use expected value to predict the possible losses they may have to cover. For each policyholder, they estimate the probability of certain events (like an accident or an illness) and the losses that would result if these events occur. Then they use the formula for expected value to calculate the average loss they can expect per policyholder.
03

Determining Insurance Premiums using Expected Value

The insurance company sets the premium to cover the expected value of the loss, plus running costs, and profit. They also include a 'risk premium' to compensate for the chance that losses are higher than expected. This calculated premium is what the policyholder is charged for insurance coverage. In principle, higher risk customers (like elderly or sick individuals or bad drivers) have higher expected losses, which results in higher insurance premiums.

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