Sunday 5th December, 2004

 

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Money Matters
with Raziah Ahmed

In quantitative business analysis, there is a discipline first expounded by Von Neuman and Morgenstern called decision analysis.

This is based on three types of decision-making environments: decision making under certainty, decision making under uncertainty, and decision making under risk.

In financial services, there is an old saying that the only things certain are death and taxes. Everything else is uncertain or a risk.

In financial planning, risk can be differentiated into pure risk and speculative risk. Pure risk is that an outcome will result in loss or the alternative is an outcome with no loss. Speculative risk occurs in a situation where there can be gain or loss. A classic example of a speculative risk, is the purchase of a lotto ticket.

When you purchase a lotto ticket, you can either lose that cash outright, or you can win real dollars. This is a win or lose situation. Similarly, when you purchase a stock, which represents equity in a company, the stock value can increase or it can fall below your purchase price. If you redeem stocks when the value falls below purchase price, you lose. That purchase is a speculative risk.

Life Insurance and property insurance products cover pure risk and they are not associated with speculative risk since you cannot possibly realise a net gain from life insurance or property insurance. You can merely recover your loss up to the amount of coverage you purchase.

So people buy insurance to cover the risk of loss.

There are a few primary risks that one may seek to cover with insurance.

Through the medium of life insurance, one may cover the risk of loss of income, due to death and disability. Life insurance does not seek to place a value on the life of the individual insured. It seeks to replace a quantum of income necessary for the family or the beneficiaries to continue putting bread on the table.

National Insurance

In the absence of life insurance, where can a family find the money that was being provided by the bread winner, who dies prematurely or becomes disabled? In an ideal society, all the members of the community will contribute to the upkeep of the family.

But we are not an ideal society. The State tries to make a provision for this contingency through the medium of the National Insurance Scheme. Last week we discussed the various benefits of the National Insurance Scheme. The quantum of such benefits is very small, and serves to provide a safety net to prevent the family from falling into poverty. This is essentially welfare.

The consumer has a choice. Should he settle for welfare benefits, (for which he pays an NIS contribution) or can he provide better than welfare for his family, in the event that death or disability occurs? If the choice is to provide more than welfare, life insurance providers are prepared to shoulder the risk of loss, in exchange for a fee, called a premium.

Decision tree

Insurance will never compensate for the worth of the life that is lost, or the loss of ability to work, but it will always provide the family with a certain level of income with which it can take care of its affairs.

Decision theorists like to draw something called a decision tree, to plot the various scenarios, that reflect probability and possible outcomes.

Ordinary people should engage in scenario plotting too, since the universe has a way of making room for those persons who know where they are going.

©2003-2004 Trinidad Publishing Company Limited

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