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Some Fundamental Theorems of Risk Management
Author(s): N. A. Doherty
Source: The Journal of Risk and Insurance, Vol. 42, No. 3 (Sep., 1975), pp. 447-460
Published by: American Risk and Insurance Association
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N. A.
DOHERTY
ABSTRACT
This paper explores the role of premium loadings in risk management
decisions. It shows how the expected utility hypothesis might be applied
to risk management situations and how rational insurance decisions
depend on the nature of the premium loading. Finally the paper
examines the 'moral hazard' argument that insurance discourages expenditure on loss prevention. The relationship between insurance and
loss prevention is shown to depend on the size and nature of the
premium loading.
The contribution which risk management has made to the management
sciences has been its stress on the interdependence between the alternative
methods of handling risk. It therefore becomes inappropriate for a firm
to formulate an optimal insurance program without reference to its program for loss prevention. Conversely, the viability of any given loss prevention program depends on the level of insurance and the conditions
under which it is arranged. The purpose of this paper is to show how the
nature and extent of this interdependence rest upon the premium structure
and, in particular, the size and structure of the premium loadings.
The importance of the premium loadings for optimal insurance and
risk management decisions has been recognized by several economists and,
collectively, their works form a theoretical basis for risk management.
Some of the more important conclusions from this literature are brought
together here and this is used as a basis for further exploration of the
relationship between risk management decisions and premium loadings.
Risk Management and Expected Utility Hypothesis

An individual or firm starts with an initial level of wealth, A, which is
exposed to the prospect of destruction or damage by some specified perils.
The analysis of this paper is appropriate in the case where the wealth is
in the form of a proprietorial interest in certain productive assets or consumer goods.
N. A. Doherty, B.Phil., F.C.I.I., is Stewart WrightsonResearchFellow in the
Universityof Nottingham,United Kingdom.
This paperwas submittedin April,1974.
This paper is part of a wider study into the economicsof insuranceand loss preventionsponsoredby StewartWrightson,Ltd. The authorwishes to recordhis thanks
to them and to an anonymousreferee of this journalwho has made many helpful
suggestions.
(447)

448
The Journal of Risk and Insurance
The potential losses to the individual can be described in the form of

a probability distribution such as that shown in Figure la. Here the value
0 on the x axis represents a zero loss and the value ON is the maximum
Loss
distribution
1~~a
FIGUREla
Expected income
distribution
lb
FIGURElb
possible loss the individual can sustain. It is useful to consider this loss
distribution in a slightly different form, where the horizontal axis records
not the loss itself but how much wealth or income remains after the loss
and/or any insurance premium has been deducted. In Figure lb, OA is
the initial wealth and the outcome x = 0 represents a total loss. Figure lb
is simply a mirror image of la. This distribution is referred to as the
expected income distribution. Clearly the individual can change the shape
of his expected income distribution by purchasing insurance and in the
limiting case full insurance would be represented by a distribution which
showed an outcome of A - R with an associated probability of 1. The
term R denotes the insurance premium.
Decisions facing the firm about whether it purchases insurance, or
how much it purchases, might be graphically represented as a choice
between various probability distributions each of which corresponds to
a different level of insurance. One device for ranking competing distributions is the expected utility hypothesis' by which each distribution can be
associated with a real number and the ordering of these real numbers
provides a preference ordering over the various probability distributions.
Figure 2 combines four separate diagrams, the first of which, 2(a),
shows the probability distribution f(x) appearing in lb which shows the
income prospect if no insurance is purchased. Directly underneath 2a is
a utility of income function U1(x). This satisfies the requirement of diminishing marginal utility of income,2 which implies aversion to risk. The
horizontal axis of 2b has the same variable. as the horizontal axis of 2a and
furthermore they are drawn on the same scale. Part 2c is merely a 45
'See for example K. H. Borcb, "The Economics of Uncertainty," Princeton Studies
in Mathematical Economics No. 2, Ch. 3.
2 For our application, the utility function must also satisfy the well-known Von
Neumann/Morgenstern axiom and be determined up to linear transformation.

-V9
____________._
__
_____
jNO
____
__
*%
449
_ ___/&
FIGURE 2. The Bernoulli Theorem
U~~~~~
olL
A~ t
!IAx
0
FIGURE 3.
ON
X~~~~~~~
Risk Aversion and the Demand for Insurance
/dgree line which renders the horizontal axis of 2c directly comparable

-withthe vertical axis of 2b. The final part of Figure 2 can now be used to
-constructwhat might be called the "utility equivalents"of the probability
Zlistributions;it is from these that a preference ordering can be obtained.

450
The utility equivalent of the probability distribution can be constructed

as follows. For any possible outcome, e.g. (x = x:), there is an associated
probability, p(xj), shown on the vertical axis of 2(a). If u, is individual
I's utility function, then xj can be given a utility "value" or index U(xj).
The co-ordinates U(xj) and P(xj) can now be plotted in 2(d) and are
shown with an X. By repetition the whole distribution g(U1(x) ) can be
constructed.3 If one wishes to establish a preference ordering over several
probability distributions drawn in 2a then all that needs to be done
from the expected utility hypothesis is to compare the means of the
corresponding distributions appearing in 2d.
The standard propositions about insurance purchasing under actuarially
fair premiums can now be clearly illustrated. The actuarial premium is
OA-OD where 1 is the mean of f(x). With full insurance the individual's
income will be '1 with certainty. This prospect is shown as 0 on the U (x)
axis. However, if he does not insure, the expected utility is the mean of
g(U,(x) ) which is (? on the U(x) axis. The ordering is such that the
full insurance prospect is preferred. The result depends on the concavity
of the utility function to the x axis. If it had been linear, (0 and ? would
coincide indicating that the individual is indifferent between full insurance and self insurance. If the utility function were convex (0 and 0
would have the reverse ordering thereby indicating a preference for self
insurance even at actuarial premiums.
Turning back to U1(x), if the premium quoted by the insurers is OAOX1 then a situation of indifference between full insurance and self insurance results since the expected utilities from these alternatives are equal.
The difference between OIDand OA1 measures the risk premium or, in other
words the maximum sum the individual is willing to pay in order to offload the risk. The risk premium is dependent upon the intensity of aversion
to risk.4 Figure 3 is drawn along similar lines to Figure 2 but a second
utility function U2(x) has been added.
U2(x) is constructed to display a lower intensity of aversion to risk than
U1(x) and the effect is that the risk premium is reduced to O-D-OX2.
In the limiting case where the utility function is linear, the risk premium
will be zero. These propositions are of an 'all or nothing' nature, whereas
risk management has underlined the possibility that the optimal insurance
strategy may well involve some measure of risk sharing between the
insurer and the insured. The next section considers the optimality conditions for various forms of risk sharing.
Optimality Conditions for Insurance and Risk Retention
Risk sharing is commonly practiced in many insurance markets but it
appears in various forms. Coinsurance occurs where the insurers limit their
liability to a given percentage of any loss. A deductible is a fixed sum
3 Formally g(U1(x) ) = f (x) for all x.
4 Intensity of risk aversion is measured by the coefficient of risk aversion. The
absolute coefficient of risk aversion is given by U"/U' for each level of x. See J. W.
Pratt "Risk Aversion in the Large and in the Small," Econometrica 32, (Jan.-April
1964) and K. J. Arrow "Aspects of the Theory of Risk Bearing," Helsinki 1965.

451
deduction from each claim so that the insured himself bears losses below
this sum. Where the loss exceeds this sum the insurers pay the difference.
A franchise is similar to a deductible but, unlike it, the insurers are fully
liable for losses over the deductible amount. A fourth form of risk sharing
is the first loss arrangement. Here, the insurers will pay the amount of
the loss or a given sum, whichever is the lower. The text concentrates on
the optimality conditions for coinsurance and deductibles, although an
attempt is made later to order these and other forms of risk sharing.
If the income prospect is represented in the form of a discrete probability distribution the expected utility is given by
n
I
where
pJU(A - L;)
is the probability that a loss of

size Li will occur
A is initial wealth
U is the appropriate utility function
n is the number of possible outcomes
(including the outcome in which
no loss occurs)
pi
Fortunately the presentation can be simplified very considerably by considering a binomial probability distribution in which only two outcomes
are possible. This simplification does not affect the main conclusions of
the paper, as can be demonstrated easily by appropriate differentiation
with a multi outcome distributions There is a probability p that a loss
will occur and it will assume a single value L. This state is denoted by
subscript 0. There is a residual probability (1-p) that no loss will occur;
that state being denoted by subscript 1. If no insurance is purchased, the
expected utility of the income prospect is given by: 6
U
+ pU(A- L)
(1 - p)U(A)
Coinsurance
If the individual or firm coinsures, the expected utility is given by:
III(i)
(1 - p)U(A -
=w L) + pU(A- =w L - (1-
where a is the proportion of insurance
7r
)L)
is the price of insurance.7
5Many of the writers cited here take advantage of this simplification because it can
be used to produce fairly general results.
6The presentation here is similar to that of Ehrlich and Becker. However, a difference does arise in the definition of the price of insurance. Here, it is defined as the rate
at which certainty income can be transformed into income in state 0 only. The reason
for using this definition is that insurers rarely make the payment of premium contingent
on whether a loss occurs. Thus the E & B symbols are equivalent to my aL - a7rL or,
in other words, my net insurance payment in state 0 is functionally related to r. See
I Ehrlich and G. S. Becker, "Market Insurance, Self Insurance and Self Protection"
J.P.E. Vol. 80, 1972.
7 Incomes in each state of the world are defined net of tax. If premiums and uninsured
losses are both tax deductible, then the real price of insurance is the rate at which
net of tax premiums can be used to make good contingent net of tax losses.

452
The optimality conditionsare given by:

dU =
da
111(ii)
-(1
- p)U'w L
~~1
pU0L( w
pUL7r1
where U1 is the marginal utility of income if state 1 occurs
and
III(iii)
d2U
-2
d a
(1.-
2
p) (7r L) U1
2
p(L(7r-1))U0<
If premiums are actuarially fair, then 7r = p and it is clear from III(ii)

that U,'= U0'thus implying equalisation of wealth in both states of the
world or, in other words, full insurance. If premiums are calculated on
the basis of a proportionateloading upon the actuarialvalue8 then III(ii)
becomes:
(1 - p)(1
III(ii)a
+ m)LU{
p((l
+ m)p -
1)LUt
where m is the loading factor. Since p is positive then if m>O the equation
can only be satisfied if Ud>U?. If the utility function is concave this

implies that actual income in state 0 must be less than in state 1. Consequently less than full insurance will be optimal. This conclusion is
reached by both Mossin and Smith.9
If the loading factor is independent of the actuarialvalue (premium =
apL + m) then the optimality conditions are apparently similar to the
actuarialcase. The first order condition reduces to:
III(ii)b
p(l
- p)U{L
p(l
- p)U'L
which implies full insurances However, this case does present the possibility of a corner solution,"1in which case calculus techniques will fail to
reveal the optimal solution. The loading is apparently a "lump sum tax"
which applies to all policyholders but its imposition may be avoided if
no insuranceis purchased.The expected utility function thereforebecomes
discontinuousat a = 0. The optimal solution will then either be the full
insurancesolution (a= 1) given by equation III(ii)b or the corner solution (a = 0) in which no insuranceis purchased.
8 In which case the premium= apL ( 1+m) where m is the loading factor.
J. Mossin, "Aspects of Rational Insurance Purchasing,"J.P.E. 76 (July-Aug. 1968)
V. L. Smith, "Optimal Insurance Coverage," J.P.E. 76 (Jan.-Feb. 1968).
'0This conclusion is reached by Parkin & Wu who point out that if the premium
loading is independent
of the actuarial value ". . . the optimality conditions between
the actuarial and non-actuarial schemes are identical." See J. M. Parkin & S. Y. Wu,
"Choices Involving Unwanted Risky Events and Optimal Insurance," A.E.R. 62 (Dec.
1972).
"- This point has been made by M. Jones-Lee in an unpublished paper.

453

Deductibles
The optimality conditionsfor deductibles turn out to be similarto those

for coinsurance.The expected utility from the income prospect is given by:
U
III(iv)
(1 - p)U(A-
+ pU(A -
(L -))
wr(L-)-)
where A is the deductible

The maximisingconditions are given by
III (v)
dd
(1 - p)Ulr
pU(
r-1)
which implies full insurance if the premium is actuarially fair (7 = p); and
III (v)
d2U
(_-
2 "(1-
U"Tr2
)Ul
1
pUO(X -1)
<
which holds if U" < 0. With a proportionate loading the first order condition is:
III(vii)
(1 - p)(l
+ m)pU{
p((1
+ m)p -
M)UI
which if m > 0 and p > 0 implies that U01> U I which in turn implies
less than full insurance. If the premium includes a lump sum loading,
the result is the same as that considered under coinsurance.If insurance
is purchasedat all, then full insurancewill be optimal. However, the lump
sum tax itself might be sufficientto dissuade firms from buying insurance.
Summarising,the Mossin and Smith theoremsshow that partial insurance
will always be optimal where a proportionateloading is imposed.12 At
first sight, it seems that most property insurances are calculated on the
basis of proportionateloadings. A common practice of property insurers
is to use target loss ratios as the basis of premium calculations.'3The
premiums for each class of insureds are calculated at a set ratio of the
expected claims costs.'4 Where coinsuranceis undertakenat some given
percentagethe premiumis usually, though not always, the same percentage
of the full insurancepremium and the assumptionsof Mossin and Smith
seem appropriate.
However, when risk sharing takes the form of deductibles, franchisesor
first loss policies, then the premium loadings are not likely to be of a
simple proportionate nature if only because this would involve a detailed
12 Sometimes the insured is only offered a limited number of choices. For example,
he may be offered either full cover at a stated premium or a given deductible at an
alternative premium. In these cases it is impossible to anticipate the ordering of these
alternatives unless the insured's utility function is exactly specified.
13 See Report on the Supply of Fire Insurance, The Monopolies Commission, London
HMSO, 2nd August 1972, paras 168-178.
14Each class contains a group of insureds who are considered to be relatively
homogeneous in terms of loss expectancies.

454
knowledge of the loss density function. Premium structures often contain

crude or arbitrary premium reductions for deductibles and, in the case
of larger insureds, the premium reduction is often determined by bargaining between the insurer and the insured and/or his brokers. It is therefore important to state the conditions under which risk sharing may be
optimal in terms of the premium saving and in a way which applies to
each of the forms of risk sharing.
In Figure 4 the distribution f(x) represents the individual's expected
income if he does not insure (i.e. it is comparable with f (x) in Figures
lb, 2a and 3a). If he fully insures, then his expected income will be the
initial wealth OA minus the required premium R1. In other words his
expected income is OB with a probability of one. R,
(OA - OC) is the
premium for coinsurance at the rate of fifty percent of all losses and the
appropriate distribution for 50 percent coinsurance is g(x). The diagram
is constructed so that the mathematical value of g(x) is equal to OB or,
in other words, the actuarial values of the coinsurance option and the
full insurance option are equal.
If the utility equivalent distribution had been drawn, as in Figures 2
and 3, and the utility function were linear, then clearly the firm would be
indifferent between full insurance and coinsurance. If, however, the utility
function were concave, the expected utility theorem, as illustrated in
Figures 2 and 3 suggests that full insurance would be preferred. Furthermore, concavity of the utility function suggests that the coinsurance option
would never be chosen unless its actuarial value exceeded that of the
full insurance option.
arc
RI
FIGURE 4.
The Preconditions for Risk Retention
This conclusion can be presented in another manner. The actuarial

value of the coinsurance option can only exceed that of the full insurance
option if the premium reduction for coinsurance is greater than the actuarial
value of the uninsured risk. In order to induce a risk averter to coinsure,

Some Fundamental Theorenmof Risk Management
455
it is a necessary, but not sufficient, condition that the reduction in premium

exceeds the actuarial value of the uninsured risk. The term "risk sharing"
can be substituted for coinsurance in the last sentence since it can be
shown that it also applies to other forms of partial insurance.
This coinsurance condition is compatible with the theorems of Mossin
and Smith since they assume the premium loading to be a percentage
markup on the actuarial value.'5 On the other hand, if the premium
loading is independent of the actuarial value, i.e. a lump sum tax, then
the conditions for risk sharing are not met, and as seen above, the firm
will either fully insure or escape the tax altogether by self insuring. In
principle the application of the condition to more complex premium structures is simple, though of course in practice knowledge of the probability
distribution is required.
Arrow"' has shown that, given a choice between two policies of equivalent actuarial value, a risk averter would prefer one with a deductible to
one subject to coinsurance. This ranking can be extended to produce a
preference ordering over the various forms of risk sharing.
The effects of the various forms of risk sharing on the individual's expected income distribution are shown in Figure 5. In all cases the maximum
attainable wealth is the initial wealth OA minus the premium OA-GB.
The effect of coinsurance is to compress the possible outcomes over a
smaller range of values of x and in figure 5(a). Insuring with a deductible
has the effect of chopping off the tail of the original density function and
replacing this with a probability mass at the wealth value relating to the
deductible (i.e. c in figure 5(b) ). A franchise has a similar effect to the
deductible but the probability mass is replaced at a wealth level relating
to the initial wealth minus the insurance premium (B in fig. 5(d) ). The
first loss policy effectively extracts the probability mass relating to losses
between zero and the upper limit and replaces this with a probability
mass at the initial wealth minus the insurance premium (see fig. 5(c) ).
The model developed earlier can now be used to yield a preference
ordering over the various forms of risk sharing, on the assumption that the
actuarial values of all the alternative policies are identical. This is done
by pairing off the distributions and comparing the means of their utility
equivalents. To illustrate, the deductible policy and the first loss policy
are compared in fig. 6. In part (a) the probability distributions relating
to the two options are constructed; the deductibles option denoted by
diagonal shading and the first loss option is not shaded. The actuarial
values of the two options are identical at 4a, but in part (b) which shows
the utility equivalent distributions it is seen clearly that the deductible
option has a higher utility value ( (2) on the U(x) axis) than the first
loss option ( (1) on the U(x) axis.) This outcome is a necessary conse15 If the insurers charge a premium of (1 + m) times the expected claims cost then
the premium reduction will be (1 + m) times the expected value of the uninsured risk.
"6K. J. Arrow, "Uncertainty and the Welfare Economics of Medical Care," A.E.R.
Vol. LIII No. 5, (December 1963).

456
t~~~~D~vdb/ zQB-OC
i,
Thy)
frnchis
~FrJ E Loss
piu6
x~~~~
FIGURE 5. Alternative Methods of Risk Sharing
sowf 9cle
deducyibcK
a)
fte
|;e
Pva *>
4
<
dedmlcfibk_ )
(6)
s/4
0p
FIGURE 6. Comparison of Deductible and First Loss Policies
quence of the concavity of the utility function and similar comparisons

show the deductiblespolicy to be preferredto each of the other alternatives
and both the franchise and coinsurancepolicies preferred to the first loss
policy.

457
Interdependence Between Insurance and Loss Prevention

Loss prevention provides an alternative strategy towards risk. The firm
may be able to reduce the probability that a certain undesirable event will
occur, or reduce the financial impact if it does occur, by means of safety
devices. These may include sprinkler systems, burglar alarms, safer working procedures, etc. The optimal size for a loss prevention program is
defined where the costs and benefits are equated at the margin. However,
these costs and benefits depend on the level of insurance and the conditions
under which it is transacted. The effect of risk transfer is to relieve the
insured of the direct financial consequences of certain events and this in
turn implies a zero sum gain from the installation of safety devices. This
may lead to a change in loss probabilities, which is described as moral
hazard. Counteracting this, the insurers might devise premium structures
which grant premium reduction for loss prevention systems. For example,
under an actuarially fair premium structure, the expected return from a
loss prevention program for a firm which is fully insured is the reduction
in the expected value of the loss; this is, of course, the same expected
return as in the case where no insurance is purchased.
The interdependence between insurance and loss prevention is shown
by considering exogenous changes in the level of insurance on the optimality conditions for loss prevention. This will reveal whether insurance and
loss prevention are complements or substitutes. The utility of the income
prospect is:
IV(i)
(1 - p(r))U(A - = L w(r) - r
p(r)U(A- =Lr (r) -(1 -)L
- r)
where r is the level of expenditure on loss prevention, and the other symbols
are as expressed earlier.
The optimal level of loss prevention for any given level of insurance is
given by the first order condition:
IV(ii)
au
-pb(r)
(A - as ''L - r) - U(A -
U
-(1
- p(r))U;(
'(r)L
(r)L - (1 -L
+ 1)
+ 1) - p(r)UO(s: v(r)L
- r
0
and the appropriate second order condition. In order to show the effect of
exogenous changes in the level of insurance on self protection expenditure,
take the derivative of the first order condition; this gives dr/da =-N/m
where M is the second order condition, which will be negative, so that
the sign of dr/da will be the same as the sign of N. N is given by:
IV(iii)
p' (r){UL
-(1
- p(r]UlL
-p(r)UOL
In the actuarial case, 7r(r)

IV(iv)
Lp' (r)(2p(r)
i(r)
:'(r)
I' (r)
- 1)(U;
- UoL( ir(r) - 1)}

+
(1 - p(r))U"(
p(r)U
-L :'(r)
( -L rI(r)
+ 1)L x(r)
+ 1) (L( ir)
1))
p(r) and N simplifies to:

1
- U1) +
L(
Lp(r) + 1)p(r)(1
- p(r))(
p 0)(U

~Ulf
458
Ehrlich and Becker point out that in this case market insurance and
loss prevention may turn out to be complementary if p is not very small
and U is concave.17, 18 However, a similar result may occur where the
premium includes a loading factor. For example, if the premium includes
a lump sum loading (premium= aLp (r) + k) then N would be the
same as in the actuarial case. Since M also would be unchanged then
the rate of substitution would be identical.
A more interesting case is where the loading is related to the sum insured.
By substituting a premium of the form ap (r) L + akL into IV (i) and
appropriate differentiation, N emerges as follows:
IV(v)
pL(r)L(2p(r)
- UO)
k -
-L(
+ 1)f(p(r)
Lp'(r)
- P
kp(r))(U'
- U") +kUl}
As with the actuarial case, this may result in complementarity between

insurance and loss prevention if p is not very small and U is concave.
For example, if U is quadratic then insurance and loss prevention will be
complements if (2p(r) + k - 1) > 0. (This is a sufficient, but not necessary, condition.)
The widespread use of target loss ratios implies a proportionate loading
factor. By substituting 7r(r) = (1 + m )p (r) where m>1 and appropriate
differentiation, then N becomes:
IV(vi)
p' (r)L{(2p(r)(1
+
L(
+ m) -
L(1 + m)p'(r)
1){P(r)(1
-mUjj-
- p(r)
- mp(r)) (U" - U") + mp(r)U';}
The conditions for a positive sign for this expression are more complex.
For example, if U is quadratic then N will certainly be positive if
(a)
U2p r)(1
m) - 1) > 0
(b)
Ulf
.Tr
p(r)( L(1 +7;mpI W -+1)
and
PI W
and may be positive if only one of these conditions is met. Furthermore,

complementarity is likely to occur at lower levels of p under a proportionate loading than in the actuarial or lump sum cases. It may also be noted
that the lower the coefficient of risk aversion the more likely it is that
insurance and loss prevention will turn out to be complementary. In the
limit, dr/da will certainly be positive if U is linear since the firm will
maximize its expected return.
It is interesting to compare the expected payback to loss prevention
expenditure under different assumptions about the premium loading. In
Figure 7, the expected payback to a loss prevention program is defined
"ISee Ehrlich and Becker, op. cit., p. 642.
8 Note hat (aLp'(r) + 1) is positive by the first order condition.

459
as the reduction in the expected loss. The size of the loss prevention program
is assumed a continuous variable. The line OX measures the payback
to loss prevention assuming no insurance is purchased and the dotted line
is a simple 450 device. A program of size OR would equate cost with
Paybackt
/45
/o55/Ptenevr6of
AOX
A/,'
i0 S r
FIGURE
7.
The Payback to Loss Prevention
expected payback and a programof size OSwould yield the highest margin
of expected payback over cost. In the actuarial case, the payback would
be exactly the same as in the no insurancecase and the firm which sought
to maximise expected income would optimize at OS. Similarly with the
lump sum loading, the payback is (E, + m) - (E, + m.) (where E, is
the expected loss before the program and E, is the expected loss after
the program and m, is the loading) which is again shown by OX.With a
proportionateloading the expected payback is (I + m) (E - E2). This
results in a new curve OZwhich gives a higher payback for any given
programand maximisesnet payback at a higher level of loss prevention.
The phenomenon described by insurers as moral hazard implies that
insureds substitute between insurance and loss prevention. The notion
was challenged by the Ehrlich and Becker conclusion that if premiums
are actuarially fair and loss probabilities are fairly high then insurance
and loss prevention may well be complimentary.In fact, a stronger conclusion can be reached under less unrealistic assumptions. Where the
premium loading is positively related to the actuarialvalue then complementarity is likely to ensue at lower levels of loss probability and/or
where the insured'scoefficientof risk aversionis relatively low.
Conclusion
The theorems which are summarised and extended in this paper are
quite specific and there is little need to repeat them. As an explanationof
risk management behaviour the value of these -theorems is limited by
the paucity of data on loss probabilities.Access to such data is obviously
crucial in co-ordinatingstrategies towards risk but it is also importantin

460
defining and identifying premium loadings. In practice, if the premium

loading is to be related mathematically to the actuarial value of the policy
then the expression must contain some random error because the actuarial
value itself is not known with certainty. Perhaps one of the strongest points
of the rational model is that it draws attention to the type of information
which is required for better risk management.


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Some Fundamental Theorems of Risk Management

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

Some Fundamental Theorems of Risk Management

Risk Management and Expected Utility Hypothesis

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

The Journal of Risk and Insurance

The potential losses to the individual can be described in the form of

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

Some Fundamental Theorems of Risk Management

FIGURE 2. The Bernoulli Theorem

Risk Aversion and the Demand for Insurance

/dgree line which renders the horizontal axis of 2c directly comparable

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

The Journal of Risk and Insurance

The utility equivalent of the probability distribution can be constructed

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

Some Fundamental Theorems of Risk Management

is the probability that a loss of

where a is the proportion of insurance

is the price of insurance.7

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The Journal of Risk and Insurance

The optimality conditionsare given by:

where U1 is the marginal utility of income if state 1 occurs

If premiums are actuarially fair, then 7r = p and it is clear from III(ii)

can only be satisfied if Ud>U?. If the utility function is concave this

of the actuarial value ". . . the optimality conditions between

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

Some Fundamental Theorems of Risk Management

The optimality conditionsfor deductibles turn out to be similarto those

where A is the deductible

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The Journal of Risk and Insurance

knowledge of the loss density function. Premium structures often contain

The Preconditions for Risk Retention

This conclusion can be presented in another manner. The actuarial

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

Some Fundamental Theorenmof Risk Management

it is a necessary, but not sufficient, condition that the reduction in premium

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The Journal of Risk and Insurance

FIGURE 5. Alternative Methods of Risk Sharing

FIGURE 6. Comparison of Deductible and First Loss Policies

quence of the concavity of the utility function and similar comparisons

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Some Fundamental Theorems of Risk Management

Interdependence Between Insurance and Loss Prevention

p(r)U(A- =Lr (r) -(1 -)L

In the actuarial case, 7r(r)

- UoL( ir(r) - 1)}

p(r) and N simplifies to:

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The Journal of Risk and Insurance

As with the actuarial case, this may result in complementarity between

- mp(r)) (U" - U") + mp(r)U';}

p(r)( L(1 +7;mpI W -+1)

and may be positive if only one of these conditions is met. Furthermore,

This content downloaded from 200.16.5.202 on Wed, 11 Jun 2014 17:26:43 PM

Some Fundamental Theorems of Risk Management

The Payback to Loss Prevention

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The Journal of Risk and Insurance