Ambiguity on the Insurer's Side: The Demand for Insurance

46 Pages Posted: 30 Jan 2015 Last revised: 18 Jun 2015

See all articles by Massimiliano Amarante

Massimiliano Amarante

University of Montreal

Mario Ghossoub

University of Waterloo

Edmund S. Phelps

Center on Capitalism and Society, Columbia University

Date Written: January 27, 2015

Abstract

Empirical evidence suggests that ambiguity is prevalent in insurance pricing and underwriting, and that often insurers tend to exhibit more ambiguity than the insured individuals (e.g., Hogarth and Kunreuther (1989)). Motivated by these findings, we consider a problem of demand for insurance indemnity schedules, where the insurer has ambiguous beliefs about the realizations of the insurable loss, whereas the insured is an expected-utility maximizer. We show that if the ambiguous beliefs of the insurer satisfy a property of compatibility with the non-ambiguous beliefs of the insured, then optimal indemnity schedules exist and are monotonic. By virtue of monotonicity, no ex-post moral hazard issues arise at our solutions (e.g., Huberman, Mayers, and Smith (1983)). In addition, in the case where the insurer is either ambiguity-seeking or ambiguity-averse, we show that the problem of determining the optimal indemnity schedule reduces to that of solving an auxiliary problem that is simpler than the original one in that it does not involve ambiguity. Finally, under additional assumptions, we give an explicit characterization of the optimal indemnity schedule for the insured, and we show how our results naturally extend the classical result of Arrow on the optimality of the deductible indemnity schedule.

Keywords: Optimal Insurance, Deductible, Ambiguity, Choquet Integral, Distorted Probabilities

JEL Classification: G22

Suggested Citation

Amarante, Massimiliano and Ghossoub, Mario and Phelps, Edmund S., Ambiguity on the Insurer's Side: The Demand for Insurance (January 27, 2015). Journal of Mathematical Economics, Vol. 58, No. 1, 2015. Available at SSRN: https://ssrn.com/abstract=2556114 or http://dx.doi.org/10.2139/ssrn.2556114

Massimiliano Amarante

University of Montreal ( email )

C.P. 6128 succursale Centre-ville
Montreal, Quebec H3C 3J7
Canada

Mario Ghossoub (Contact Author)

University of Waterloo ( email )

Dept. of Statistics & Actuarial Science
200 University Ave. W.
Waterloo, Ontario N2L 3G1
Canada

HOME PAGE: http://uwaterloo.ca/scholar/mghossou

Edmund S. Phelps

Center on Capitalism and Society, Columbia University ( email )

420 W. 118th Street
New York, NY 10027
United States
212-854-2060 (Phone)
212-854-8059 (Fax)

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