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On the preference for full-coverage policies: Why do people buy too much insurance?

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  • Shapira, Zur
  • Venezia, Itzhak
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    Abstract

    One of the most intriguing questions in insurance is the preference of consumers for low or zero deductible insurance policies. This stands in sharp contrast to a theorem proved by Mossin [Mossin, J. (1968). Aspects of rational insurance purchasing. Journal of Political Economy, 76, 553-568], that under quite common assumptions when the price of insurance is higher than its actuarial value, then full coverage is not optimal. We show in a series of experiments that amateur subjects tend to underestimate the value of a policy with a deductible and that the degree of underestimation increases with the size of the deductible. We hypothesize that this tendency is caused by the anchoring heuristic. In particular, in pricing a policy with a deductible subjects first consider the price of a full-coverage policy. Then they anchor on the size of the deductible and subtract it from the price of the full-coverage policy. However, they do not adjust the price enough upward to take into account the fact that there is only a small chance that the deductible will be applied toward their payments. We also show that professionals in the field of insurance are less prone to such a bias. This implies that a policy with a deductible priced according to the true expected payments may seem "overpriced" to the insured and therefore may not be purchased. Since the values of full-coverage policies are not underestimated the insured may find them as relatively better "deals".

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Psychology.

    Volume (Year): 29 (2008)
    Issue (Month): 5 (November)
    Pages: 747-761

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    Handle: RePEc:eee:joepsy:v:29:y:2008:i:5:p:747-761

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    Web page: http://www.elsevier.com/locate/joep

    Related research

    Keywords: Anchoring Insurance pricing Behavioral finance Biases;

    References

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    1. James J. Choi & David Laibson & Brigitte C. Madrian & Andrew Metrick, 2004. "For Better or for Worse: Default Effects and 401(k) Savings Behavior," NBER Chapters, in: Perspectives on the Economics of Aging, pages 81-126 National Bureau of Economic Research, Inc.
    2. Uri Gneezy & John List & George Wu, 2006. "The uncertainty effect: When a risky prospect is valued less than its worst possible outcome," Framed Field Experiments 00152, The Field Experiments Website.
    3. Wakker, P.P. & Thaler, R.H. & Tversky, A., 1997. "Probabilistic insurance," Discussion Paper, Tilburg University, Center for Economic Research 1997-35, Tilburg University, Center for Economic Research.
    4. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
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    6. Kahneman, Daniel, 1992. "Reference points, anchors, norms, and mixed feelings," Organizational Behavior and Human Decision Processes, Elsevier, Elsevier, vol. 51(2), pages 296-312, March.
    7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
    8. Rajnish Mehra & Edward C. Prescott, 2003. "The Equity Premium in Retrospect," NBER Working Papers 9525, National Bureau of Economic Research, Inc.
    9. W. Kip Viscusi & Richard J. Zeckhauser, 2006. "National Survey Evidence on Disasters and Relief: Risk Beliefs, Self-Interest, and Compassion," NBER Working Papers 12582, National Bureau of Economic Research, Inc.
    10. Shlomo Benartzi & Richard H. Thaler, 2002. "How Much Is Investor Autonomy Worth?," Journal of Finance, American Finance Association, vol. 57(4), pages 1593-1616, 08.
    11. Johnson, Eric J, et al, 1993. " Framing, Probability Distortions, and Insurance Decisions," Journal of Risk and Uncertainty, Springer, vol. 7(1), pages 35-51, August.
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    13. Michael Braun & Alexander Muermann, 2004. "The Impact of Regret on the Demand for Insurance," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 71(4), pages 737-767.
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    Cited by:
    1. Jean Desrochers & J. Francois Outreville, 2013. "Uncertainty, Ambiguity and Risk Taking: an experimental investigation of consumer behavior and demand for insurance," ICER Working Papers, ICER - International Centre for Economic Research 10-2013, ICER - International Centre for Economic Research.
    2. Li, Chu-Shiu & Lin, Chih Hao & Liu, Chwen-Chi & Woodside, Arch G., 2012. "Dynamic pricing in regulated automobile insurance markets with heterogeneous insurers: Strategies nice versus nasty for customers," Journal of Business Research, Elsevier, vol. 65(7), pages 968-976.
    3. Coble, Keith H. & Barnett, Barry J. & Riley, John Michael, 2013. "Challenging Belief in the Law of Small Numbers," 2013 AAEA: Crop Insurance and the Farm Bill Symposium, October 8-9, Louisville, KY 156958, Agricultural and Applied Economics Association.
    4. Xiaodong Du & Hongli Feng & David A. Hennessy, 2014. "Rationality of Choices in Subsidized Crop Insurance Markets," Center for Agricultural and Rural Development (CARD) Publications 14-wp545, Center for Agricultural and Rural Development (CARD) at Iowa State University.

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