CHAPTER • Uncertainty and Consumer Behavior 173 a large loss Now suppose that 100 people are similarly situated and that all of them buy burglary insurance from the same company Because they all face a 10-percent probability of a $10,000 loss, the insurance company might charge each of them a premium of $1000 This $1000 premium generates an insurance fund of $100,000 from which losses can be paid The insurance company can rely on the law of large numbers, which holds that the expected loss to the 100 individuals as a whole is likely to be very close to $1000 each The total payout, therefore, will be close to $100,000, and the company need not worry about losing more than that When the insurance premium is equal to the expected payout, as in the example above, we say that the insurance is actuarially fair But because they must cover administrative costs and make some profit, insurance companies typically charge premiums above expected losses If there are a sufficient number of insurance companies to make the market competitive, these premiums will be close to actuarially fair levels In some states, however, insurance premiums are regulated in order to protect consumers from “excessive” premiums We will examine government regulation of markets in detail in Chapters and 10 of this book In recent years, some insurance companies have come to the view that catastrophic disasters such as earthquakes are so unique and unpredictable that they cannot be viewed as diversifiable risks Indeed, as a result of losses from past disasters, these companies not feel that they can determine actuarially fair insurance rates In California, for example, the state itself has had to enter the insurance business to fill the gap created when private companies refused to sell earthquake insurance The state-run pool offers less insurance coverage at higher rates than was previously offered by private insurers • actuarially fair Characterizing a situation in which an insurance premium is equal to the expected payout EX AMPLE THE VALUE OF TITLE INSURANCE WHEN BUYING A HOUSE Suppose you are buying your first house To close the sale, you will need a deed that gives you clear “title.” Without such a clear title, there is always a chance that the seller of the house is not its true owner Of course, the seller could be engaging in fraud, but it is more likely that the seller is unaware of the exact nature of his or her ownership rights For example, the owner may have borrowed heavily, using the house as “collateral” for a loan Or the property might carry with it a legal requirement that limits the use to which it may be put Suppose you are willing to pay $300,000 for the house, but you believe there is a one-in-twenty chance that careful research will reveal that the seller does not actually own the property The property would then be worth nothing If there were no insurance available, a risk-neutral person would bid at most $285,000 for the property (.95[$300,000] + 05[0]) However, if you expect to tie up most of your assets in the house, you would probably be risk averse and, therefore, bid much less—say, $230,000 In situations such as this, it is clearly in the interest of the buyer to be sure that there is no risk of a lack of full ownership The buyer does this by purchasing “title insurance.” The title insurance company researches the history of the property, checks to see whether any legal liabilities are attached to it, and generally assures itself that there is no ownership problem The insurance company then agrees to bear any remaining risk that might exist