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Insurance demand and prospect theory

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  • Schmidt, Ulrich

Abstract

Empirical evidence has shown that people are unwilling to insure rare losses at subsidized premiums and at the same time take-up insurance for moderate risks at highly loaded premiums. This paper explores whether prospect theory, in particular diminishing sensitivity and loss aversion, can accommodate this evidence. A crucial factor for applying prospect theory to insurance problems is the choice of the reference point. We motivate and explore two possible reference points, state-dependent initial wealth and final wealth after buying full insurance. It turns out that particularly the latter reference point seems to provide a realistic explanation of the empirical evidence.

Suggested Citation

  • Schmidt, Ulrich, 2012. "Insurance demand and prospect theory," Kiel Working Papers 1750, Kiel Institute for the World Economy (IfW Kiel).
    • Handle: RePEc:zbw:ifwkwp:1750
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    References listed on IDEAS

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    Cited by:

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    More about this item

    Keywords

    insurance demand; prospect theory; flood insurance; diminishing sensitivity; loss aversion;
    All these keywords.

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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