Economics of Insurance Ref. Gravelle & Rees: Microeconomics, Chapter 19, section D & E.

RISK SPREADING: THE ARROW-LIND THEOREM Here we investigate the effect on the premium of sharing the insured risk among an increasing number of insurers. We show that, as the number of risk-averse insurers sharing the risk increases, the premium paid by the insured will tend to the expected cost of the accident or event insured against, i.e. to the actuarially fair premium. MODEL: Let there are n members in a syndicate. They are willing to pay to acquire a risky project for which they will equally share the gains and losses. We assume that the syndicate member have identical preferences, probability beliefs and income. The income of a representative member of the syndicate in state s is: ys+kZs-p ------ (1) ys : original state-contingent income Zs: payyoff from the risky prospect k=1/n: fraction of the prospect received by each individual of the syndicate. p:amount paid by each member for the right to share in the risky prospect. & P = np is the amount that syndicate pays for the prospect and shares the cost equally amont the members. We consider ys and Zs are statistically independent: cov(ys, Zs)=0 ----------(2)

The maximum price (p) each member of the syndicate would be willing to pay for her share that satisfies: E [v(ys+kZs-p)] = E[v(ys)] -------------(3)

The expected value of the individual share in the prospect is: kE[Zs]. Therefore, risk loading is: l = kE[Zs] p ------------ (4)

(Excess of expected return over price). Now, the prospect payoff in state s can be written as: Where es : random deviation with E(es) =0 Therefore, (3) can be written as: E [v(ys+kZs-p)] = E[v(ys+kZs - kE(Zs)+l)] = E[v(ys+kes+l)] = E[v(ys)] ------- (6) Zs = E(Zs) +es -------- (5)

Equation (6) the risk loading is the compensation required to make the individual accept the risky but fair bet which pays : kes = kZs - kE(Zs) in state s.
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Economics of Insurance Ref. Gravelle & Rees: Microeconomics, Chapter 19, section D & E.

Therefore, the risk loading depends upon the share of the risky prospect borne by each syndicate member: l = l(k) = l(1/n) ------- (7)

Now, the maximum amount that the syndicate would pay for the risky prospect is: P = np = n[kE(Zs)-l(k)] = nkE(Zs)-nl(k) = n.kE(Zs)-n.l(1/n) If n.l(1/n) risky prospect. ----------- (8)

0 as n becomes large: a large syndicate will be willing to pay the expected value of the

Using the Implicit Function Theorem1we can find the effect of the members share k on her risk loading from (6). Since R.H.S is independent of k, we can write:

. ,

---- (9)

Since, Zs =E(Zs) +es is not correlated with ys, es is also uncorrelated with ys.hence the only sourse of correlation b/w (MU of income) and es that as es increases decreases2, i.e., , 0. As n increases, k=1/n decreases i.e, l(k) decreases. ------- (10)

Hence we can make the following proposition: Total risk loading tends towards zero as n becomes large: . /

----- (11)

Since both the numerator and the denominator of l(k)/k goes to zero, we use LHspitals Rule / , , /

Hence (11) holds & so large syndicates of risk averse members will be willing to contract as though they are all risk-neutral. The total risk loading n.l(1/n) tends to zero as the syndicate size increases b/e the risk loading of each member decreases faster than the rate at which the syndicate size n is increasing.

Given F(y,x)=0, if an implicit function y = f(x) exist, then the implicit-function-rule gives : dy/dx = -Fx/Fy. See Fundamental Methods of Mathematical Economics, Alpha. C. Chiang, page 204-208.
2

As " 0, and no correlation between es and ys, an increase in es leads to a fall in .

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Economics of Insurance Ref. Gravelle & Rees: Microeconomics, Chapter 19, section D & E.

RISK POOLING Suppose there are n individuals identically and independently distributed. yi: random income of ith indiv. without pooling that is continuously distributed within the interval [0,1] and has the distribution function F(yi). we now prove the following proposition:

Equal shares pooling scheme: the n members put their realized incomes yi into the pool and share out the total realized income equally. The random pooled income of each member can be written as:

--------- (1) Alternative pooling scheme: the scheme gives some individual member of the pool the share ki of the income of the jth member of the pool, where ki (1/n) for some i3. The random income of such a member would be:

------- (2)4

where we have substituted for yn from (1). Hence in this alternative pooling scheme the income of a member = random income under equal share pooling [w(n)] + weighted sum of further n-1 variables. Let yi-yn = difference between the random incomes of the ith and nth individual. Let Sin = sum of realizations of all n-2 random incomes except yi and yn so that
3

E.g: sharing scheme of two individual: individual-1 gets k share of his realized income and (1-k) share of the realized income of individual-2. Therefore, w(k) = ky1+(1-k)y2 = y2 + k(y1-y2).

In this alternative scheme an n member pool decides to give the first n-1 members 1/n-1 of their total realized income and the nth member just yn identical to n-1 member pool with an optimal equal shares scheme for its members.

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Economics of Insurance Ref. Gravelle & Rees: Microeconomics, Chapter 19, section D & E.

The probability that yi - yn = y given that the realized value of w(n)=w is:

-------- (3)

------ (4)

Now let us consider the probability that

------- (5)

Since yi and yn are identically distributed, (4) and (5) are equal and the events that

Hence the expected value of yi yn given w(n) is zero. From (2), w(k) is sum of w(n) + n-1 random variable with zero mean for given w(n).

So, risk averters prefer w(n) to w(k). Hence equal shares pooling scheme is optimal. : Proof of the proposition.

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