Financial literacy and precautionary insurance
Annette Hofmann and
No 34/19, ICIR Working Paper Series from Goethe University Frankfurt, International Center for Insurance Regulation (ICIR)
This paper studies insurance demand for individuals with limited financial literacy. We propose uncertainty about insurance payouts, resulting from contract complexity, as a novel channel that affects decision-making of financially illiterate individuals. Then, a trade-off between second-order (risk aversion) and third-order (prudence) risk preferences drives insurance demand. Sufficiently prudent individuals raise insurance demand upon an increase in contract complexity, while the effect is reversed for less prudent individuals. We characterize competitive market equilibria that feature complex contracts since firms face costs to reduce complexity. Based on the equilibrium analysis, we propose a monetary measure for the welfare cost of financial illiteracy and show that it is mainly driven by individuals' risk aversion. Finally, we discuss implications for regulation and consumer protection.
Keywords: financial literacy; insurance demand; prudence; precautionary insurance (search for similar items in EconPapers)
JEL-codes: D11 D81 D91 G22 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fle, nep-ias, nep-mic and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:icirwp:3419
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