The Good. The Bad. The Asinine.

I have an idea… Part 2

Regular readers of this blog will have recently attended their first actuarial lecture. Some of you may have learned something (see Note 1 below if you didn’t), but, at the very least, you all realised that actuarial lectures are awesome, and you have a strong desire to attend more.

Well, if there’s one thing I hate, it’s disappointing my regular reader. So here goes… Lecture 2 starts now.
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Suppose you live on the planet Fluff. As it turns out, Fluff is very similar to Earth, and Fluffers, as Fluff’s inhabitants are known, are very similar to us humans. They breathe oxygen, eat chicken parmigiana, and mostly work in the porn industry. There are a few differences, however. For starters, they are lucky enough to have 11 Kardashians. They also have a different god to us, and life is a little different under the Fluffer god:

  1. Instead of being called ‘God’, their god insists on being called by his name, which is John.
  2. John’s pretty nice, and spends all his time preventing heart attacks, lung cancer, and lightning strikes, such that no one ever dies before the age of 80.
  3. As soon as someone turns 80, John sends a taxi to bring them to heaven. The really devout people get a stretch Hummer. Fckwits get a Camry.

As you might have guessed, Fluffers don’t really have a huge need for life insurance, given that everyone knows exactly when they’re going to die. And on the few occasions someone is actually stupid enough to take out a policy, the actuaries have it pretty easy – “Oh, you’re 30, and want $50,000 when you die? That’ll be 50 thousand divided by 50, please, whatever that is.” (Note 2)

One day John decides that life on Fluff is a little boring. So he determines that he’s not going to stop people having heart attacks any more. And while everyone was a little shocked when Betsy dropped dead at her 30th birthday party, (a) no one was surprised to see a Camry pull up out the front, and (b) people soon realised that life insurance might be a good idea.

That was a crazy day over at Mutual Fluffing, I can tell you. Thousands of people ringing up for life insurance, management in a panic, the call centre, whose name was Jarad, didn’t know how to work the phone… only the actuaries remained cool, which was the first time actuaries had been described with that particular adjective.

“Don’t panic!” they said. “We’ll just see how many people die of heart attacks over the next year. If we divide that by the total population, that will give us a rough idea of the probability of dying of a heart attack. Then if someone wants to insure their life for $100,000, we can just multiply that amount by the probability of dying, and that will give us the expected value of the policy. And that’s the premium we should charge.”

And John saw the way the actuaries were calculating premiums, and saw that it was good.

Things carried on in this way for a while, until one day the actuaries noticed something unusual. Looking at the characteristics of all the people dying, they noticed that men tended to have a lot more heart attacks than women – around twice as many, in fact. This created a few problems:

  1. While they were collecting the right amount of premium in total, if men were having twice as many heart attacks as women, they were also paying half as many premiums.
  2. If men were paying half the number of premiums, then, in order to keep everything fair, each premium should be twice as much. That is, men were getting their insurance at half price, and the women were making up the shortfall.
  3. If insurance was relatively cheap for men, and relatively expensive for women, women would soon stop buying it.

The actuaries realised that if they wanted to continue selling life insurance, they’d have to charge different premiums for men and women. So that’s what they did.

And John saw the way the actuaries were calculating premiums, and saw that it was good.

Eventually, however, John realised that he actually didn’t like Fluffers that much after all, so he decided to stop preventing lung cancer, too. Once again there was a mild panic at Mutual Fluffing, and, once again, the actuaries had the answer.

“You know what we’ve noticed about all these people dying from lung cancer? They’re all smokers. If we want premiums to remain fair, we need to charge smokers a higher premium than non-smokers.” So that’s what they did.

And John saw the way the actuaries were calculating premiums, and saw that it was good.

Ultimately, however, John accepted that he actually wasn’t very nice after all. In fact, he was a bit of a wanker, and couldn’t be bothered stopping anyone dying. And if you paid attention earlier, you’ve by now realised what that meant – people started getting zapped by lightning.

“Actuaries, actuaries! What do we do now?!” pleaded the managers at Mutual Fluffing.

“Hmm… Well, lightning doesn’t discriminate by sex or age. And people don’t choose to get struck by lightning. It’s just a completely random event that no one has any control over. So we should just increase everyone’s premium by the same amount.”

And John saw the way the actuaries were calculating premiums, and realised something important – something that would come in handy if he ever stumbled across an awesome blog on Earth. Each premium was comprised of three components:

  1. Things that increased the risk, but over which the life insured had no control (e.g. sex);
  2. Things that increased the risk, and which the life insured could control (e.g. smoking);
  3. Risks that no one could predict, or control.

Or, if he needed a catchy phrase that was easy to remember – “People are things, people do things, and shit happens”.

He also realised that it was probably time that the Son of John left home. In a Camry.

But that’s another story.

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Footnotes

  1. You learned that an expected value is an average outcome for a wide range of probabilities and consequences, and we should be indifferent between two sets of events that have the same expected value. Or you would have if you’d paid attention. (back)
  2. Premium payable annually in advance, and assumes John’s monetary policy is so effective that it keeps interest rates at 0% at all times. Also assumes that John’s bans on expenses, regulatory capital, profit, and coveting your neighbour’s ox remain in place. (back)

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