Insurance and Actuarial Science – Part II

 Insurance and Actuarial

Actuarial science is the study of
risk using mathematical and statistical methods in insurance, finance, and
other industries and professions. Mathematics, probability theory, statistics,
finance, economics, and computer science are all interrelated topics in
actuarial science. Historically, deterministic models were used in the
construction of tables and premiums in actuarial science.

Utilitarianism as a philosophy and
risk aversion as a feature of human psychology both contribute to the evolution
of financial security systems as a means of mitigating the financial
consequences of unfavorable events. When used as a noun, the term
“risk” expresses the possibility of loss or injury. The same word can
also be used as a verb to describe exposing one’s person or property to loss or
injury. There are thus two distinct elements within the common meaning of
“risk,” the idea of loss or injury, and the idea of uncertainty.
Theft, embezzlement, and negative court judgments all result in wealth loss and direct economic loss forms. In short, the loss or injury is frequently
quantifiable in monetary terms.

Economic risk prevention or mitigation

We have police protection,
self-defense techniques, rescue organizations, safety equipment, and so on to
reduce the risk to the individual. We use fire departments, smoke or burglar
alarms, security systems, and building codes to protect property. The first
line of defense against any loss is to reduce the likelihood that an adverse
event will occur or to reduce the damage if such an event does occur. Economic
loss is no exception. However, many types of economic loss cannot be avoided. Even when first-order defense mechanisms are most effective,
there are certain thresholds below which the likelihood of economic loss or the
severity of damage cannot be reduced. Recognizing these constraints, modern
society has devised strategies for dealing with the financial consequences of
economic risk, even if the risk itself cannot be avoided. For the purposes of
this monograph, we will refer to these methods as “financial security
systems.” These systems have a special relationship with the actuary. This
relationship’s existence and significance are one of the pillars upon which
actuarial science is built. Financial security systems are based on the
principle that risk-averse people would rather take a small but certain loss
than a large uncertain one. When economic loss cannot be avoided, it is
frequently shared. The basic concept is the pooling of economic risk, which
results in a small loss to many rather than a large loss to a few unfortunate
individuals. For the purposes of this monograph, we define a financial security
system as an economic system that is primarily designed to transfer economic
risk from an individual to an aggregate or collective of individuals, or from
one collector to another.

Transfer mechanisms for financial

Financial security systems can also
be thought of as transfer mechanisms, in which money is transferred from one
group or class of people to another. Transfers from the many who did not
experience the insured against an event to the few who did are at the heart of
financial security systems. Secondary transfers are also used in financial
security systems. Employee benefit plans use an “employer” transfer as
part of the system by which employees are compensated for their work. The
social security system is based on a “transgenerational” transfer.
Some financial security systems, particularly those run by the government based on public welfare, are “subsidies” paid to one group of
people by another. Such systems are not covered by the standard definition of
insurance. However, we include systems that use secondary transfers in this
category because they fit the definition, we chose for financial security

The Basic Utilities Philosophy

Most modern economic systems,
whether capitalistic or socialist, are based on the philosophic principle of
utilitarianism, which is defined as doing the best for the greatest number of
people over the longest period of time. Financial security systems are built on
the same foundation. Jeremy Bentham and John Stuart Mill were classical
utilitarian philosophers who wrote in the nineteenth century in the United
Kingdom. Perhaps a majority of more recent philosophers advocate some form of
the same utilitarian concept, and it is unmistakably the guiding principle of
much of modern western society. Whether the good that utilitarians seek to maximize
is referred to as “happiness,” “pleasure,” or
“utility,” and whether the maximization is individual or collective,
are debatable, but the general principle appears to be widely accepted.

Theory of utility and aversion to

Given a set of axioms for preference
coherence, one can demonstrate the existence of a real number utility function
defined on the set of world states while preserving the individual’s preference
ordering. The fact that a person’s expected utility for uncertain future wealth
is similar to, but not identical to, the expected value of future wealth is an important part of modern utility theory. People are not indifferent between a
large but uncertain loss and a small but certain loss, preferring the latter in
general. Risk aversion, which is primarily a psychological phenomenon, is a
component of utilitarianism and thus a component of the rationale underlying
modern financial security systems.

The Role of Actuarial sciences

Financial security systems have
become the domain of the actuary, just as economic systems are the domain of
the economist, social systems are the domain of the sociologist, and electrical
systems are the domain of the electrical engineer. The actuary’s understanding
of financial security systems in general, and the inner workings of the many
different types in particular, distinguishes the profession. The actuary’s role
is that of a designer, adaptor, problem solver, risk estimator, innovator, and
technician in the ever-changing field of financial security systems. However,
the actuarial profession recognizes that the actuary’s role is not exclusive.
Many other people, whether professionals or not, play an important role in
financial security systems. If financial security systems are to be successful
in minimizing the financial consequences of economic risk, actuarial skills
must be combined with the capabilities of others. Furthermore, some

systems fit our definition where the actuary has had little influence, at
least in the past. This may be especially true for government systems dealing
with public assistance or welfare, as well as those dealing with financial
markets. Even systems with the word “insurance” in their names, such
as the FHA’s mortgage insurance1, the Federal Deposit Insurance
Corporation2, and the United States and Canadian unemployment
insurance systems, operate largely without actuarial assistance.

Insurance and Actuarial Science

1A Federal Housing Administration (FHA) loan is a mortgage insured by the FHA and issued by an FHA-approved lender. FHA loans are
intended for borrowers with low-to-moderate income; they have a lower minimum
down payment and credit requirements than many conventional loans.

2The Federal Deposit Insurance Corporation (FDIC) is an independent
agency established by Congress to maintain financial stability and public
confidence in the United States. The FDIC insures deposits, examines, and
supervises financial institutions for safety, soundness, and consumer
protection, resolving large and complex financial institutions, and managing

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