ABSTRACT
Insurance companies exist because of the fact that people and companies are generally averse to risk. The essence of the business is that insurance is offered to a population of people that are potentially exposed to the risk of events that could have adverse šnancial consequences. By pooling the risks of a large number of people who are risk averse, the insurance company can offer an insurance policy at a price to the client that will cover its expected losses and administrative costs, and clients will be willing to pay this premium to avoid the šnancial consequences of their individual potential losses. Of course, things get complicated when we consider that individuals vary in their riskiness and their attitudes to risk and that the offer
of voluntary insurance may itself impact the risks people take (known as moral hazard), as well as affect the likely purchasers of an insurance policy (i.e., adverse selection). These are all interesting complications, but for an insurance company to be able to offer and price insurance policies, it needs to be able to estimate both the frequency of losses and the severity of these losses when they occur.
