Alexander Adamou, Ole Peters

Paper #: 15-07-029

We present a mathematical solution to the insurance puzzle. Our solution only uses time-average growth rates and makes no reference to risk preferences. The insurance puzzle is this: according to the expectation value of wealth, buying insurance is only rational at a price that makes it irrational to sell insurance. There is no price that is beneficial to both the buyer and the seller of an insurance contract. The puzzle why insurance contracts exist is traditionally resolved by appealing to utility theory, asymmetric information, or a mix of both. Here we note that the expectation value is the wrong starting point – a legacy from the early days of probability theory. It is the wrong starting point because not even the most basic models of wealth (random walks) are stationary, and what the individual experiences over time is not the expectation value. We use the standard model of noisy exponential growth and compute time-average growth rates instead of expectation values of wealth. In this new paradigm insurance contracts exist that are beneficial for both parties.