Utility & Risk

Why insurance makes sense

An interactive lesson with 6 steps, about 5 minutes: you predict, drag and solve, with instant feedback on every answer. It runs in your browser and needs JavaScript.

What you’ll learn

• Utility functions like $\log w$ capture diminishing returns.
• The certainty equivalent of a gamble is less than its expected value for risk-averse people.
• Insurance trades a small certain loss for protection against ruin; people also feel losses more than gains.

Steps

1. Diminishing returns
2. Find the certainty equivalent
3. Why buy insurance?
4. Pricing insurance
5. A square-root utility
6. Losses loom larger