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A Tale of Two Tails: On the Coexistence of Overweighting and Underweighting of Rare Extreme Events

Thomas Epper and Fehr-Duda, Helga ()

No 1705, Economics Working Paper Series from University of St. Gallen, School of Economics and Political Science

Abstract: Almost all important decisions in people’s lives entail risky consequences. Some of these decisions involve events that materialize with a low probability but lead to extreme consequences such as loss of total wealth or accidental death. When facing such rare extreme events, people display considerable risk aversion in some situations whereas in others the opposite is the case. For example, the prospect of airplane and stock market crashes triggers high risk aversion but there is a low willingness to take out hazard or life insurance. We address this puzzle by arguing that the timing of the consequences and of uncertainty resolution are crucial for understanding these phenomena. We show that future uncertainty conjointly with people’s proneness to probability distortions generates a unifying framework for explaining the coexistence of over- and underweighting of rare extreme events.

Keywords: Tail risk; insurance; risk preference; time preferences; extreme events; probability weighting (search for similar items in EconPapers)
JEL-codes: D01 D81 D91 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cbe, nep-ias, nep-rmg and nep-upt
Date: 2017-04
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