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Insuring a risky investment project

Author

Listed:
  • Henri Loubergé

    (University of Geneva and Swiss Finance Institute)

  • Richard Watt

    (University of Canterbury)

Abstract

In the standard model for insurance demand, the risk is totally exogenous and the insurance premium is paid for out of riskless wealth. This model yields results that are mostly in contradiction to everyday observation and have been used to question the pertinence of expected utility theory on which the model is based. For some years now, several papers have made attempts to provide foundations for a theory of insurance demand leading to less provocative comparative statics results. In these papers, the risk for which coverage is sought becomes endogenous and the decision to purchase insurance is made simultaneously with the decision how much to invest in insurable assets. All these papers use a standard financial investment framework. This paper offers a contribution to this literature by using a slightly different framework: the case of a firm exposed to an insurable risk affecting return on a real investment project. The model is kept simple by using a two-state environment. It yields results that are both more complete and more general than results in previous work with the same motivation.

Suggested Citation

  • Henri Loubergé & Richard Watt, 2006. "Insuring a risky investment project," Swiss Finance Institute Research Paper Series 06-25, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp0625
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    References listed on IDEAS

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    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. Dionne, Georges & Eeckhoudt, Louis, 1984. "Insurance and saving: some further results," Insurance: Mathematics and Economics, Elsevier, vol. 3(2), pages 101-110, April.
    3. You-Song Jang & Josef Hadar, 1995. "A note on increased probability of loss and the demand for insurance," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 20(2), pages 213-216, December.
    4. Jack Meyer & Michael B. Ormiston, 1995. "Demand for insurance in a portfolio setting," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 20(2), pages 203-211, December.
    5. Briys, Eric & Dionne, Georges & Eeckhoudt, Louis, 1989. "More on Insurance as a Giffen Good," Journal of Risk and Uncertainty, Springer, vol. 2(4), pages 415-420, December.
    6. Doherty, Neil A & Schlesinger, Harris, 1983. "Optimal Insurance in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 91(6), pages 1045-1054, December.
    7. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
    8. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-1658, December.
    9. Hoy, Michael & Robson, Arthur J., 1981. "Insurance as a Giffen good," Economics Letters, Elsevier, vol. 8(1), pages 47-51.
    10. Eeckhoudt, Louis & Meyer, Jack & Ormiston, Michael B, 1997. "The Interaction between the Demands for Insurance and Insurable Assets," Journal of Risk and Uncertainty, Springer, vol. 14(1), pages 25-39, January.
    11. Mayers, David & Smith, Clifford W, Jr, 1982. "On the Corporate Demand for Insurance," The Journal of Business, University of Chicago Press, vol. 55(2), pages 281-296, April.
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    Cited by:

    1. Zhou, Chunyang & Wu, Wenfeng & Wu, Chongfeng, 2010. "Optimal insurance in the presence of insurer's loss limit," Insurance: Mathematics and Economics, Elsevier, vol. 46(2), pages 300-307, April.

    More about this item

    Keywords

    insurance coverage; risk aversion; normality; Giffen good; actuarially fair premium;

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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