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Insurance demand and prospect theory

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  • Schmidt, Ulrich

Abstract

Empirical evidence 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. This paper explores whether prospect theory, in particular diminishing sensitivity and loss aversion, can accommodate this evidence. A crucial factor for applying prospect theory to insurance problems is the choice of the reference point. We motivate and explore two possible reference points, state-dependent initial wealth and final wealth after buying full insurance. It turns out that particularly the latter reference point seems to provide a realistic explanation of the empirical evidence.

Suggested Citation

  • Schmidt, Ulrich, 2012. "Insurance demand and prospect theory," Kiel Working Papers 1750, Kiel Institute for the World Economy (IfW Kiel).
    • Handle: RePEc:zbw:ifwkwp:1750
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    File URL: https://www.econstor.eu/bitstream/10419/55277/1/684387875.pdf
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    References listed on IDEAS

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    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. 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.
    4. Peep F.M. Stalmeier & Thom G.G. Bezembinder, 1999. "The Discrepancy between Risky and Riskless Utilities," Medical Decision Making, , vol. 19(4), pages 435-447, October.
    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.
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    11. repec:bla:scotjp:v:47:y:2000:i:2:p:183-97 is not listed on IDEAS
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    Cited by:

    1. K. P. M. Winssen & R. C. Kleef & W. P. M. M. Ven, 2016. "Potential determinants of deductible uptake in health insurance: How to increase uptake in The Netherlands?," The European Journal of Health Economics, Springer;Deutsche Gesellschaft für Gesundheitsökonomie (DGGÖ), vol. 17(9), pages 1059-1072, December.
    2. Robin Maialeh, 2019. "Generalization of results and neoclassical rationality: unresolved controversies of behavioural economics methodology," Quality & Quantity: International Journal of Methodology, Springer, vol. 53(4), pages 1743-1761, July.
    3. Daniel Osberghaus, 2017. "Prospect theory, mitigation and adaptation to climate change," Journal of Risk Research, Taylor & Francis Journals, vol. 20(7), pages 909-930, July.

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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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