Insurance Premium Calculation under Continuous Cumulative Prospect Theory

23 Pages Posted: 4 Feb 2019

See all articles by Martina Nardon

Martina Nardon

Ca Foscari University of Venice - Dipartimento di Economia

Paolo Pianca

Ca Foscari University of Venice - Dipartimento di Economia

Date Written: January 17, 2019

Abstract

We define a premium principle under the continuous cumulative prospect theory which extends the equivalent utility principle. In prospect theory risk attitude and loss aversion are shaped via a value function, whereas a transformation of objective probabilities, which is commonly referred as probability weighting, models probabilistic risk perception. In cumulative prospect theory, probabilities of individual outcomes are replaced by decision weights, which are differences in transformed, through the weighting function, counter-cumulative probabilities of gains and cumulative probabilities of losses, with outcomes ordered from worst to best. Empirical evidence suggests a typical inverse-S shaped function: decision makers tend to overweight small probabilities, and underweight medium and high probabilities; moreover, the probability weighting function is initially concave and then convex. We study some properties of the behavioral premium principle. We also assume an alternative framing of the outcomes; then we discuss several applications to the pricing of insurance contracts.

Keywords: Continuous Cumulative Prospect Theory, Insurance Premium Principles, Zero Utility Principle, Framing, Probability Weighting Function

JEL Classification: D81, G22, G41

Suggested Citation

Nardon, Martina and Pianca, Paolo, Insurance Premium Calculation under Continuous Cumulative Prospect Theory (January 17, 2019). University Ca' Foscari of Venice, Dept. of Economics Research Paper Series No. 03/WP/2019 , Available at SSRN: https://ssrn.com/abstract=3324183

Martina Nardon (Contact Author)

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

Paolo Pianca

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy
+390412346915 (Phone)
+390415221756 (Fax)

HOME PAGE: www.dma.unive.it/~pianca

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