The Behavioral Economics of Insurance
AbstractWe 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 InfoPaper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 10/12.
Date of creation: Apr 2010
Date of revision: Apr 2010
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Find related papers by JEL classification:
- C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-05-02 (All new papers)
- NEP-EVO-2010-05-02 (Evolutionary Economics)
- NEP-IAS-2010-05-02 (Insurance Economics)
- NEP-UPT-2010-05-02 (Utility Models & Prospect Theory)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ali al-Nowaihi & Sanjit Dhami, 2010. "Probability Weighting Functions," Discussion Papers in Economics 10/10, Department of Economics, University of Leicester.
- 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.
- 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.
- 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.
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