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On the Preference for Full-Coverage Policies: Why do People buy too much Insurance?

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  • Zur Shapira
  • Itzhak Venezia
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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, 1968, 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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    File URL: http://ratio.huji.ac.il/sites/default/files/publications/dp460.pdf
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    Bibliographic Info

    Paper provided by The Center for the Study of Rationality, Hebrew University, Jerusalem in its series Discussion Paper Series with number dp460.

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    Length: 29 pages
    Date of creation: Aug 2007
    Date of revision:
    Handle: RePEc:huj:dispap:dp460

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    1. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    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.
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    7. Sendhil Mullainathan & Richard H. Thaler, 2000. "Behavioral Economics," NBER Working Papers 7948, National Bureau of Economic Research, Inc.
    8. 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.
    9. Mehra, Rajnish & Prescott, Edward C., 2003. "The equity premium in retrospect," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 14, pages 889-938 Elsevier.
    10. 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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