with Raziah Ahmed
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
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.
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
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.
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.