The Behavioral Economics of Insurance

Ali al-Nowaihi () and Sanjit Dhami

No 10/12, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

Abstract: We focus on four stylized facts of behavior under risk. Decision makers: (1) Overweight low probabilities and underweight high probabilities. (2) Ignore events of extremely low probability and treat extremely high probability events as certain. (3) Buy inadequate insurance for very low probability events. (4) Keeping the expected loss fixed, there is a probability below which the take-up of insurance drops dramatically. Expected utility (EU) fails on 1-4. Existing models of rank dependent utility (RDU) and cumulative prospect theory (CP) satisfy 1 but fail on 2, 3, 4. We propose a new class of axiomatically-founded probability weighting functions, the composite Prelec weighting functions CPF) that simultaneously account for 1 and 2. When CPF are combined with RDU and CP we get respectively, composite rank dependent utility (CRDU) and composite cumulative prospect theory (CCP). Both CRDU and CCP are able to successfully explain 1-4. CCP is, however, more satisfactory than CRDU because it incorporates the empirically robust phenomena of reference dependence and loss aversion.

Keywords: Decision making under risk; Insurance; Composite Prelec probability weighting functions; Composite rank dependent utility theory; Composite cumulative rospect theory; power invariance; local power invariance (search for similar items in EconPapers)
JEL-codes: C60 D81 (search for similar items in EconPapers)
Date: 2010-04, Revised 2010-04
New Economics Papers: this item is included in nep-evo, nep-ias and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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