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Insurance and Endogenous Bankruptcy Risk: When is it Rational to Choose Gambling, Insurance, and Potential Bankruptcy?

Author

Listed:
  • Lisa L. Posey

    (Pennsylvania State University)

  • Vickie Bajtelsmit

    (Colorado State University)

Abstract

We examine the coexistence of insurance and gambling in the context of limited liability. We develop a model where actuarially fair insurance is available to a risk-averse decision maker for a liability risk with non-bankrupting severity. The remaining wealth may be invested in a zero expected value risky project (i.e., gambled). The risk of bankruptcy is endogenous since either fully insuring or forgoing the project will guarantee solvency. We show that, for a range of parameters, it is optimal to both insure and gamble. The amounts insured and invested are chosen to create the potential for bankruptcy. Our results are robust to the cases where the risky project can cause bankruptcy without a liability loss and where the risky project’s expected return is nonzero.

Suggested Citation

  • Lisa L. Posey & Vickie Bajtelsmit, 2017. "Insurance and Endogenous Bankruptcy Risk: When is it Rational to Choose Gambling, Insurance, and Potential Bankruptcy?," The Geneva Papers on Risk and Insurance Theory, Springer;International Association for the Study of Insurance Economics (The Geneva Association), vol. 42(1), pages 15-40, March.
    • Handle: RePEc:kap:geneva:v:42:y:2017:i:1:d:10.1057_s10713-016-0016-x
    DOI: 10.1057/s10713-016-0016-x
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