Sunday, January 06, 2008

Risk aversion III - the lottery and insurance

Risk aversion is of great interest financially. If we can model risk aversion or better put risk taking accurately it opens up the possibility to be able to work out for instance:
  • What risks a person offers for personal insurance purposes and therefore whether an individual should be insured or what premiums they should pay. Here risk aversion is seen as a positive, insurance companies want risk averse people as clients. It is less likely that you will have to make a payout with a risk averse person as opposed to a risk taker. Or are they? Are risk averse individuals safer?
  • The other side of the insurance coin and risk is how likely the individual is to take out insurance anyway. So it might be that the more risk averse you are the more likely it is that you will buy insurance.
  • Investment companies want to know how risk averse an investor is so that they can sell the appropriate products. Indeed in investment terms risk adversity is described as how much risk an individual will hold for the likelihood of similar returns. The most risk averse tend to go for things like building societies or premium bonds where they are either guaranteed a certain return or at least their money back.
  • One angle of economic risk looks at whether an individual actually saves 'for a rainy day' or just lives for today with the expectation that their income will continue.
  • Another angle of economic risk is what people will do to earn money. Are they most likely to be employed, self employed or casual or even work in the black economy (prostitution, drug selling, selling things for cash outside of the state taxation system for example).
  • Gambling is another financial risk activity. Now where the line is between gambling and investment and speculation is a fruitful area for discussion. However there are more and less risky gambling activities.
It is tempting to say that a risk averse person will be:
  1. Good to insure - least likely to engage in risky activities and therefore have accidents
  2. Most likely to want insurance - least likely to risk being uninsured
  3. Most likely to save regularly - least likely to spend, spend, spend.
  4. Will tend to save in 'safe' institutions - as opposed to making high risk investments
  5. Most likely to be in employment in a safe job - least likely to engage in high risk or illegal occupations
  6. Unlikely to gamble, however if they do are most likely to go for safe bets like the premium bonds.
Most of the financial risk modeling, as you would have expected , is algebraic in nature as are the financial theories. For a good overview of these see the Theory of Risk Aversion website.

So are risk averse people risk averse in all areas of their lives or do they engage in paradoxical behaviour, taking risks in some areas and not in others?
For example are risk averse people safer because they don't engage in risk laden activities or does their risk adversity make them more of a risk because they are too cautious?

The answer appears to be yes! I will explain in the next blog.

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