Insurance and Actuarial Science - Part II

 Insurance and Actuarial Science

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 security

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 systems.

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 risk

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 receiverships.

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