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Optimal Demand for Insurance with Consumption Commitments

Author

Listed:
  • Chen Hua

    (Temple University)

  • Mahani Reza S.

    (Georgia State University)

Abstract

Some consumption goods, such as housing, involve long-term commitments and their levels of consumption can only be altered with substantial transaction costs. Even though the commitment effect on risk preferences, portfolio choice, and asset prices has been studied, little research has been conducted on its effect on insurance demand. In this paper, we propose a two-stage model to investigate the optimal demand for insurance by agents who derive utility from the consumption of two goods, an easily adjustable good (food) and a commitment good (housing). Our numerical analysis supports the prediction by Chetty and Szeidl (2007) that commitments help rationalize the high demand for insurance against moderate losses. Moreover, our model can explain the low insurance demand for catastrophic risks to some extent. We extend our model to include both insurance purchase and investment in a risky asset. Our results indicate that, with commitments, insurance appears to be a normal good within certain wealth regions. We also find that only when the initial wealth and housing are rather inconsistent individuals are likely to purchase insurance and lottery tickets simultaneously.

Suggested Citation

  • Chen Hua & Mahani Reza S., 2012. "Optimal Demand for Insurance with Consumption Commitments," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 6(2), pages 1-26, June.
  • Handle: RePEc:bpj:apjrin:v:6:y:2012:i:2:n:1
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    References listed on IDEAS

    as
    1. Levy, Haim, 1994. "Absolute and Relative Risk Aversion: An Experimental Study," Journal of Risk and Uncertainty, Springer, vol. 8(3), pages 289-307, May.
    2. Stephen H. Shore & Todd Sinai, 2010. "Commitment, Risk, and Consumption: Do Birds of a Feather Have Bigger Nests?," The Review of Economics and Statistics, MIT Press, vol. 92(2), pages 408-424, May.
    3. Grossman, Sanford J & Laroque, Guy, 1990. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Econometrica, Econometric Society, vol. 58(1), pages 25-51, January.
    4. Kenneth A. Froot, 1999. "Introduction to "The Financing of Catastrophe Risk"," NBER Chapters,in: The Financing of Catastrophe Risk, pages 1-22 National Bureau of Economic Research, Inc.
    5. J. David Cummins & Olivier Mahul, 2004. "The Demand for Insurance With an Upper Limit on Coverage," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 71(2), pages 253-264.
    6. Christian Gollier, 2003. "To Insure or Not to Insure?: An Insurance Puzzle," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 28(1), pages 5-24, June.
    7. Kenneth A. Froot, 1999. "The Financing of Catastrophe Risk," NBER Books, National Bureau of Economic Research, Inc, number froo99-1, June.
    8. Marjorie Flavin & Shinobu Nakagawa, 2008. "A Model of Housing in the Presence of Adjustment Costs: A Structural Interpretation of Habit Persistence," American Economic Review, American Economic Association, vol. 98(1), pages 474-495, March.
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