EXPECTED MONETARY VALUE
Suppose there are two investment options available to you. You will spend the same price for both options. For example, you need to deposit $100,000 for options A and B.
If you choose investment A, the probability of making a profit of $60.000 at the end of one year is 40%.
If you choose investment B, the probability of making a profit of $40.000 at the end of one year is 60%.
Which option do you prefer?
The tool we use when choosing options with probabilities is called Expected Monetary Value. It is a simple mathematical operation that needs to be done in the example above.
For Option A: 60.000 * 40% = $24,000
For Option B: 40.000 * 60% = $24,000
The resulting $24,000 is called the Expected Monetary Value. This shows us that there is no difference between the two investment options.
In summary; Impact Power * Probability indicates the amount of return we should expect from that investment.
This simple technique is interestingly involved in a lot of our daily lives.
Let’s start with a simple example:
How many times will you go to the hospital in 2022? Let’s say you get the flu once. Thus, you will pay a one-time inspection fee. How much does the hospital charge you for the examination? Let’s say $1,000.
Let's continue…
How old are you now? Let’s say you are 35 years old. Well, in this country, 35-year-old people, in a year, what percent of the probability of going to the hospital to be examined for flu? Let’s say we look at the statistical data of the past years and see it as 5%.
So, the expected monetary value for your health this year will be $1,000 * 5% = $50. However, it doesn’t make sense to set aside $50 for your health because if you’re really sick, you’ll spend $1000.
Therefore, since insurance companies see people’s risk levels and costs as a whole (they have this data), they calculate insurance premiums with similar logic and present them to you as the premium you have to pay.
(Of course, the calculation isn’t that easy, but that’s the general logic)
What factors increase your chances of getting sick? Age is the most important factor, genetic features from the family, smoking, alcohol addiction, not doing sports, environmental effects such as pandemics, seasonal effects such as weather conditions can be given as examples.
On the other hand, when you declare these negativities to the insurance company, the premium you have to pay will increase. On the other hand, if you do not declare it and you have a health problem in the future, for example, due to smoking, that insurance company will not cover your health costs due to smoking.
A similar situation applies to the insurance values of the vehicles. Insurance companies estimate how likely you will be to have an accident as a driver, and the average cost in the accident is determined from historical data, so they find the insurance cost you have to pay after adding their profits.
In summary, as the probability of being sick or having an accident increases, the premiums to be paid increase. So, could the reverse be true?
I wish people would be less harmed by smoking and alcohol, do more sports, pay more attention to their diet, so that they are less likely to get sick. Similarly, if drivers act more carefully in traffic, obey the rules, and the number of accidents will decrease within a year. Accordingly, as the probability values will decrease, the Expected Monetary Value will also decrease and will also decrease the premium to be paid.
Comments