YOu might sell insurace to a 21 year old friend. The probabilitythat a man aged

Question

YOu might sell insurace to a 21 year old friend. The probabilitythat a man aged 21 will die in the next year is about .0015. Youdecide to charge $200 for a policy that will pay $100,000 if yourfriend dies

What is your expected profit on this policy?

Although you expect to make a good profit, you would be foolish tosell your friend the policy. Why?

A life insurance company that sells thousands of policies, on theother hand, would do very well selling policies on exactly thesesame terms. Explain why.

Explanation / Answer

Expected profit = premium - E(loss) = 200 - 100000(0.0015) =50 It is foolish to sell one single insurance product to someonebecause this is very risky (high variance). If the friend dies,then we will have to pay a very high amount. However, if we sell policies to thousands of policies, thenthe risk would be spread out (variance reduces), and thus it isprofitable

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