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Insurance Industry Risks

In: Business and Management

Submitted By ruthrodr
Words 1091
Pages 5
Introduction
The averaging out of independent risks in a large portfolio is called diversification. The principle of diversification is used routinely in the insurance industry. In this paper I will talk about two different types of home insurance and talk about the different risks associated with each.

Discussion
A portfolio is used to describe a collection of securities. In finance, the risk of an individual security differs from the risk of a portfolio composed of similar securities. In order to help us understand why, Chapter 10 in the book gave a great example on insurance companies.
Let’s consider two types of home insurance: theft insurance and earthquake insurance. Lets also suppose that the risk of these two hazards is similar for a given home in a given area. Based on this information we would know that the risks of the individual policies are similar, however, the risks of the portfolios might be drastically different. For example, if the chance of theft in a given home is 1%, the insurance company would expect about 1% of the 100,000 homes in the area to experience a robbery. Thus the number of claims would be around 1,000 per year. If the insurance company holds reserves sufficient to cover roughly 1,000 claims, it will have enough to meet its obligations on its theft insurance policies.
The portfolio for the earthquake insurance is a little riskier. For example, if in a given area, the risk of an earthquake is 1%, the risk of having an earthquake so low that it might not occur. However, if it did occur, since all of the homes are in the same city, the insurance company could expect as many as 100,000 claims. As a result, the insurance company would have to hold reserves sufficient to cover claims on all 100,000 policies it wrote to meet its obligations if an earthquake occurs.
Although the risk might be the same, earthquake and theft

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