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Loss Modification Incentives for Insurers Under Expected Utility and Loss Aversion

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  • Adriaan Soetevent
  • Liting Zhou

Abstract

We investigate whether a profit-maximizing insurer with the opportunity to modify the loss probability will engage in loss prevention or instead spend effort to increase the loss probability. First we study this question within a traditional expected utility framework; then we apply Kőszegi and Rabin’s ( 2006 , 2007 ) loss aversion model to account for reference-dependence in consumer preferences. Largely independent of the adopted framework, we find that the profit-maximizing loss probability for many commonly used parameterizations is close to 1/2. So in cases where the initial loss probability is low, insurers will have an incentive to increase it. This qualifies appeals to grant insurers market power to incentivize them to engage in loss prevention. Copyright The Author(s) 2016

Suggested Citation

  • Adriaan Soetevent & Liting Zhou, 2016. "Loss Modification Incentives for Insurers Under Expected Utility and Loss Aversion," De Economist, Springer, vol. 164(1), pages 41-67, March.
    • Handle: RePEc:kap:decono:v:164:y:2016:i:1:p:41-67
    DOI: 10.1007/s10645-015-9259-7
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    More about this item

    Keywords

    Expected utility; Reference-dependent preferences; Risk; Insurance market; D03; D11; D81; L1;
    All these keywords.

    JEL classification:

    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • D42 - Microeconomics - - Market Structure, Pricing, and Design - - - Monopoly
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • L12 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Monopoly; Monopolization Strategies

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