Probability Weighting: An Incomplete Solution for Insurance Demand Puzzles

51 Pages Posted: 10 Feb 2019 Last revised: 4 Mar 2020

See all articles by Johannes Gerd Jaspersen

Johannes Gerd Jaspersen

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Richard Peter

University of Iowa

Marc A. Ragin

University of Georgia - Department of Insurance, Legal Studies, Real Estate; University of Georgia

Date Written: February 25, 2020

Abstract

Probability weighting is often used to explain insurance choices that conflict with expected utility (EU) preferences. We derive new theoretical results on the effects of probability weighting in the context of common insurance demand puzzles. We identify decreasing relative overweighting (DRO) as a useful condition on the probability weighting function for comparative statics. In a binary-risk model, probability weighting predicts higher demand than EU alone, explaining commonly-observed overinsurance of modest risks. On the contrary, probability weighting does not explain underinsurance for low-probability high-impact risks or for insurance contracts exposed to nonperformance risk.

Keywords: Insurance Demand, Probability Weighting, Non-expected Utility, Comparative Statics

JEL Classification: D11, D81, G22

Suggested Citation

Jaspersen, Johannes Gerd and Peter, Richard and Ragin, Marc A., Probability Weighting: An Incomplete Solution for Insurance Demand Puzzles (February 25, 2020). Available at SSRN: https://ssrn.com/abstract=3325564 or http://dx.doi.org/10.2139/ssrn.3325564

Johannes Gerd Jaspersen

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Schackstr. 4
Munich, DE 80539
Germany

Richard Peter (Contact Author)

University of Iowa ( email )

341 Schaeffer Hall
Iowa City, IA 52242-1097
United States

Marc A. Ragin

University of Georgia - Department of Insurance, Legal Studies, Real Estate ( email )

Athens, GA 30602-6254
United States

University of Georgia ( email )

Athens, GA 30602-6254
United States

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