Habit Formation and the Demand for Insurance

Abstract

This article models consumption and insurance decisions in a continuous-time, finite-horizon setting. We allow the consumer to acquire a "taste for the good life" by making current preferences for consumption dependent upon the individual's past consumption. The optimal consumption path is smoother and the optimal level of insurance greater in this setting than they are in an identical model without habit formation. Moreover, the optimal level of insurance increases over the planning horizon, approaching full coverage in the limit. These results help to explain the observed phenomenon of individuals' over-purchasing insurance, such as a propensity for low deductibles.

JEL Classification: E21