chapter  5
16 Pages

Derivative asset and insurance markets

This chapter discusses what many consider a boring market (insurance) and a fun market (derivatives). Both markets have similar functions. Insurance policies are sold due to both legal requirements and financial prudence. Purchasing insurance reduces the risk exposure of insured parties from unexpected costs and events. For example, a home insurance policy protects against a fire consuming a home and the homeowner’s belongings; the homeowner and insurance company have no idea whether a fire will break out in the home or the level of financial damage that will result. Further, neither party knows whether the homeowner will be culpable for a fire that leads to financial damage. Because humans are prone to error, insurance markets exist to minimize the risk of everyday life. Markets for insurance have sprung up for many unknowns, including alien abductions and earthquakes, regardless of how small the probability is of such future events occurring. The payment of an insurance premium provides incentives for insurance firms to “cover” another party against potential losses, sharing the risk by funding insurance over time. To the insured, the policy is a prepaid asset, used only under certain conditions. We see in certain examples below that insurance can be both a source of wealth and a prepaid asset simultaneously.