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Understanding Insurance as a Financial Contract: Insights and Analogies

This chapter delves into the concept of insurance as a contract designed to protect against financial losses related to underlying assets, such as properties and vehicles. Using car insurance as an example, it explains how insurance payouts are determined based on asset depreciation due to incidents like accidents. The relationship between insurance and financial options is explored, illustrating insurance as analogous to long put options, where deductibles and maximum payouts play crucial roles. This chapter provides a comprehensive view of the mechanisms of insurance and its parallels in financial markets.

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Understanding Insurance as a Financial Contract: Insights and Analogies

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  1. Chapter 3- A Insurance

  2. Insurance • Insurance is a contract that covers losses in value of the underlying. • Example: Home insurance or car insurance. If you have insured your car, and if your car decreases in value due to a car accident, you will get paid. No, loss in value no payment. • That looks like a long put option! Dr. Cevat Ertuna

  3. Exercise: Car Insurance Your car is worth NDT 395 000 Incase of accident insurance company assess the loss in value and pays you that minus the deductible. Deductible is NTD 10 000 and insurance will cost you NTD 13 000. The Payoff of this contract is as follows: Dr. C. Ertuna

  4. Exercise: Insurance Payoff Dr. C. Ertuna

  5. Exercise: Insurance Payoff Dr. C. Ertuna

  6. Insurance Payoff • Insurance payoff is like a long put option payoff. • Strike price is like Maximum payment minus deductible • Insurance companies are like writer of the put. INSURANCE = Long PUT + UNDERLYING Dr. Cevat Ertuna

  7. Options & Insurance • If we have options WITH the underlying asset then they serve as insurance. • If we have options WITHOUT the underlying asset then they are risky investment. Dr. C. Ertuna

  8. Options & Insurance • Long Put is insurance for the asset we own. • Long Call is insurance for asset we plan to own. Dr. C. Ertuna

  9. Generalized Summary Dr. C. Ertuna

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