Loss Aversion Leading to Advantageous Selection
41 Pages Posted: 6 Nov 2014
Date Written: October 31, 2014
Some insurance markets are characterized by “advantageous selection,” that is, ex-post risk and coverage are negatively correlated. We show that expectation-based loss aversion as in K'oszegi and Rabin (2006, 2007) provides a natural explanation for this phenomenon when agents face modest scale risks. More exposure to risk has two competing effects on an agent's willingness to pay for insurance: a positive effect, as in standard expected utility models; and a negative one, due to a reference effect. We determine conditions under which an insurance provider optimally sets a high price at which only low risk agents buy.
Keywords: loss aversion, advantageous selection, insurance
JEL Classification: D81, D82, D11, D42
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