A tale of two brick layers...

Sunday, October 29, 2006

First a brief description of a thing people are familiar with called insurance. In the past (probably today too) farmers and farms have used insurance as a way to address risk. It works something like this... Crops often fail, this is costly and causes great distress for a farmer. A rough definition of failure: Given weather and numerous other conditions a crop-product will not yield sufficiently to pay for its own production. The frequency with which this happens can be estimated statistically. If the estimate is good enough then its possible to insure a group of risk takers (farmers in this case) so that they need not be ruined by a failure. Insurance works like this, all who fit a risk category can be offered protection from the possibility of failure by paying a (relatively) small amount of money. Since the rate of failure can be reasonably estimated all that is needed is a sufficiently large group of at risk persons. Since only a proportion of the whole group will experience the actual failure the total amount of money needed to "rescue" these can be distributed across all the risk takers. This division of the cost of failure is the premium the insured pay.

About risk imagine a new structure is being built. Each floor of the building calls for a brick layer to complete some part of the work. Some floors are more complicated than others, some materials are more reliable than others, there are differing risks related to the various kinds of brick work. If the builder assigns the most skilled brick workers to do the riskiest work (imagine there is a risk of personal injury or financial loss) then the other workers are favored. In some respect the employer has minimized its own risk in the project while increasing the risk on the most skilled workers.