Insurance Demand II: Decisions Under Risk with Diversification Possibilities

In Chap. 3, risk management was restricted to one of two alternatives: Either leave the asset in question without insurance protection or buy a certain amount of insurance coverage. This narrow view may be appropriate for the decision situation of a household who owns just one marketable asset (e.g. a house). Closer inspection shows that even in this case, two more assets should be considered, namely health and human capital (wisdom). This gives rise to the question of whether the existence of these other assets might influence the decision to buy insurance coverage for the home. Consider a household whose human capital and hence labor income depends heavily on regional economic development. To a certain degree, it can diversify its assets by buying an apartment in a neighboring region that however has different economic prospects. In this way, it can reasonably expect that its marketable asset does not lose value at the same moment when its wage income goes down. Obviously, risk can be reduced or mitigated through diversification, an additional means of risk management.