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Insurance demand under prospect theory: A graphical analysis

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  • Schmidt, Ulrich

Abstract

This paper analyzes insurance demand under prospect theory in a simple model with two states of the world and fair insurance contracts. We argue that two different reference points are reasonable in this framework, state-dependent initial wealth or final wealth after buying full insurance. Applying the value function of Tversky and Kahneman (1992), we find that for both reference points subjects will either demand full insurance or no insurance at all. Moreover, this decision depends on the probability of the loss: the higher the probability of the loss, the higher is the propensity to take up insurance. This result can explain empirical evidence which has shown that people are unwilling to insure rare losses at subsidized premiums and at the same time take-up insurance for moderate risks at highly loaded premiums.

Suggested Citation

  • Schmidt, Ulrich, 2012. "Insurance demand under prospect theory: A graphical analysis," Kiel Working Papers 1764, Kiel Institute for the World Economy (IfW Kiel).
    • Handle: RePEc:zbw:ifwkwp:1764
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    References listed on IDEAS

    as
    1. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2008. "Third-generation prospect theory," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 203-223, June.
    2. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    3. Wakker, Peter P & Thaler, Richard H & Tversky, Amos, 1997. "Probabilistic Insurance," Journal of Risk and Uncertainty, Springer, vol. 15(1), pages 7-28, October.
    4. Howard Kunreuther & Mark Pauly, 2004. "Neglecting Disaster: Why Don't People Insure Against Large Losses?," Journal of Risk and Uncertainty, Springer, vol. 28(1), pages 5-21, January.
    5. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    6. Kunreuther, Howard & Pauly, Mark, 2006. "Insurance Decision-Making and Market Behavior," Foundations and Trends(R) in Microeconomics, now publishers, vol. 1(2), pages 63-127, April.
    7. Philip Ganderton & David Brookshire & Michael McKee & Steve Stewart & Hale Thurston, 2000. "Buying Insurance for Disaster-Type Risks: Experimental Evidence," Journal of Risk and Uncertainty, Springer, vol. 20(3), pages 271-289, May.
    8. McClelland, Gary H & Schulze, William D & Coursey, Don L, 1993. "Insurance for Low-Probability Hazards: A Bimodal Response to Unlikely Events," Journal of Risk and Uncertainty, Springer, vol. 7(1), pages 95-116, August.
    9. Han Bleichrodt & Jose Luis Pinto & Peter P. Wakker, 2001. "Making Descriptive Use of Prospect Theory to Improve the Prescriptive Use of Expected Utility," Management Science, INFORMS, vol. 47(11), pages 1498-1514, November.
    10. John C. Hershey & Paul J. H. Schoemaker, 1985. "Probability Versus Certainty Equivalence Methods in Utility Measurement: Are they Equivalent?," Management Science, INFORMS, vol. 31(10), pages 1213-1231, October.
    11. Justin Sydnor, 2010. "(Over)insuring Modest Risks," American Economic Journal: Applied Economics, American Economic Association, vol. 2(4), pages 177-199, October.
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    More about this item

    Keywords

    insurance demand; prospect theory; flood insurance; diminishing sensitivity; loss aversion;
    All these keywords.

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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