Suppose Burt and Ernie each face a 10% likelihood of breaking their leg this year (one’s a circus clown, the other a fireman). Suppose, too, that the medical costs of a broken leg run $5,000.
• What is Burt’s expected loss?
• What is the likelihood Burt will have to pay $5,000 in medical bills this year?
Now suppose Burt and Ernie decide to pool their losses.
• What is Burt’s expected loss?
• What is the likelihood Burt will have to pay $5,000 in medical bills this year?
• If Burt and Ernie pool their risks, will they reduce or transfer their total risks?