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Behavioral premium principles

Author

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  • Martina Nardon

    (Ca’ Foscari University of Venice)

  • Paolo Pianca

    (Ca’ Foscari University of Venice)

Abstract

We define a premium principle under the continuous cumulative prospect theory which extends the equivalent utility principle. In prospect theory, risk attitude and loss aversion are shaped via a value function, whereas a transformation of objective probabilities, which is commonly referred as probability weighting, models probabilistic risk perception. In cumulative prospect theory, probabilities of individual outcomes are replaced by decision weights, which are differences in transformed, through the weighting function, counter-cumulative probabilities of gains and cumulative probabilities of losses, with outcomes ordered from worst to best. Empirical evidence suggests a typical inverse-S shaped function: decision makers tend to overweight small probabilities, and underweight medium and high probabilities; moreover, the probability weighting function is initially concave and then convex. We study some properties of the behavioral premium principle. We also assume an alternative framing of the outcomes; then, we discuss several applications to the pricing of insurance contracts, considering different value functions and probability weighting functions proposed in the literature, and an alternative mental accounting. Finally, we focus on the shape of the probability weighting function.

Suggested Citation

  • Martina Nardon & Paolo Pianca, 2019. "Behavioral premium principles," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 42(1), pages 229-257, June.
  • Handle: RePEc:spr:decfin:v:42:y:2019:i:1:d:10.1007_s10203-019-00246-x
    DOI: 10.1007/s10203-019-00246-x
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    More about this item

    Keywords

    Continuous cumulative prospect theory; Insurance premium principles; Zero utility principle; Framing; Probability weighting function;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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