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The Behavioral Economics of Insurance

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  • Ali al-Nowaihi

    ()

  • Sanjit Dhami

    ()

Abstract

We focus on four stylized facts of behavior under risk. Decision makers: (1) Overweight low probabilities and underweight high probabilities. (2) Ignore events of extremely low probability and treat extremely high probability events as certain. (3) Buy inadequate insurance for very low probability events. (4) Keeping the expected loss fixed, there is a probability below which the take-up of insurance drops dramatically. Expected utility (EU) fails on 1-4. Existing models of rank dependent utility (RDU) and cumulative prospect theory (CP) satisfy 1 but fail on 2, 3, 4. We propose a new class of axiomatically-founded probability weighting functions, the composite Prelec weighting functions CPF) that simultaneously account for 1 and 2. When CPF are combined with RDU and CP we get respectively, composite rank dependent utility (CRDU) and composite cumulative prospect theory (CCP). Both CRDU and CCP are able to successfully explain 1-4. CCP is, however, more satisfactory than CRDU because it incorporates the empirically robust phenomena of reference dependence and loss aversion.

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Bibliographic Info

Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 10/12.

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Date of creation: Apr 2010
Date of revision: Apr 2010
Handle: RePEc:lec:leecon:10/12

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Related research

Keywords: Decision making under risk; Insurance; Composite Prelec probability weighting functions; Composite rank dependent utility theory; Composite cumulative rospect theory; power invariance; local power invariance;

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References

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  1. Bar-Ilan, Avner & Sacerdote, Bruce, 2004. "The Response of Criminals and Noncriminals to Fines," Journal of Law and Economics, University of Chicago Press, vol. 47(1), pages 1-17, April.
  2. Ali al-Nowaihi & Sanjit Dhami, 2010. "Probability Weighting Functions," Discussion Papers in Economics 10/10, Department of Economics, University of Leicester.
  3. Ali al-Nowaihi & Sanjit Dhami, 2010. "Composite Prospect Theory: A proposal to combine ‘prospect theory’ and ‘cumulative prospect theory’," Discussion Papers in Economics 10/11, Department of Economics, University of Leicester.
  4. Ali al-Nowaihi & Ian Bradley & Sanjit Dhami, 2006. "The Utility Function Under Prospect Theory," Discussion Papers in Economics 06/15, Department of Economics, University of Leicester.
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