Insurance Demand Under Prospect Theory: A Graphical Analysis

14 Pages Posted: 19 Feb 2016

See all articles by Ulrich Schmidt

Ulrich Schmidt

University of Kiel - Institute of Economics

Date Written: March 2016

Abstract

This article analyzes insurance demand under prospect theory in a simple model with two states of the world and fair insurance contracts. We argue that two different reference points are reasonable in this framework, state‚Äźdependent initial wealth or final wealth after buying full insurance. Applying the value function of Tversky and Kahneman ([Tversky, A., 1992]), we find that for both reference points subjects will either demand full insurance or no insurance at all. Moreover, this decision depends on the probability of the loss: the higher the probability of the loss, the higher is the propensity to take up insurance. This result can explain empirical evidence that has shown that people are unwilling to insure rare losses at subsidized premiums and at the same time take up insurance for moderate risks at highly loaded premiums.

Suggested Citation

Schmidt, Ulrich, Insurance Demand Under Prospect Theory: A Graphical Analysis (March 2016). Journal of Risk and Insurance, Vol. 83, Issue 1, pp. 77-89, 2016. Available at SSRN: https://ssrn.com/abstract=2734471 or http://dx.doi.org/10.1111/jori.12098

Ulrich Schmidt (Contact Author)

University of Kiel - Institute of Economics ( email )

Olshausenstrasse 40
24098 Kiel, 24098
Germany

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