Behavioral Aspects of Household Portfolio Choice: Effects of Loss Aversion on Life Insurance Uptake and Savings

Abstract

This paper investigates how loss-aversion affects individuals’ decisions on savings and insurance purchase. Specifically, this paper empirically tests if prospect theory’s loss aversion decreases insurance demand and increases savings demand. Prospect theory predicts that boundedly rational consumers may view pure protection insurance, such as term-life insurance, as a risky investment because the insured may lose premiums if a bad event does not occur within the pre-specified term. Hence, those who are fairly sensitive to the potential loss choose not to buy term-life insurance. Instead, they may choose a more safe option to prepare for uncertain future events by increasing precautionary saving. This paper tests such prediction using individual-level data from the Health and Retirement Study (HRS) and finds empirical evidence consistent with the prediction: loss-averse individuals are less likely to own term-life insurance and more likely to own whole-life insurance, which serves as a partial savings instrument. These individuals also hold a higher level of wealth than others, suggesting that they tend to save more (presumably for precautionary motives), all other things being equal.

Keywords: Loss aversion, Term life insurance, Whole life insurance, Precautionary saving, Prospect theory

JEL Classification: D03, D14, G22