Financial Literacy and Precautionary Insurance

41 Pages Posted: 23 Apr 2019 Last revised: 24 Mar 2020

See all articles by Christian Kubitza

Christian Kubitza

University of Bonn - Institute for Financial Economics and Statistics

Annette Hofmann

St. John's University - Peter J. Tobin College of Business

Petra Steinorth

University of Hamburg - Institute for Risk Management and Insurance

Date Written: March 18, 2020

Abstract

We study insurance markets with individuals that have limited financial literacy. In our model, complexity of insurance contracts causes individuals to be uncertain about insurance payouts. As a result, a trade-off between second-order (risk aversion) and third-order (prudence) risk preferences drives insurance demand. Very prudent individuals desire more insurance coverage when contract complexity increases, while the effect is reversed for less prudent individuals. We characterize the competitive market equilibrium with complex contracts when firms can exert costly effort to reduce complexity. Based on the equilibrium analysis, we propose a monetary measure for the welfare cost of financial illiteracy and show that it is mainly driven by risk aversion. We conclude with a discussion about implications for policy interventions and consumer protection.

Keywords: financial literacy, insurance demand, prudence, precautionary insurance

JEL Classification: D11, D81, D91, G22

Suggested Citation

Kubitza, Christian and Hofmann, Annette and Steinorth, Petra, Financial Literacy and Precautionary Insurance (March 18, 2020). Available at SSRN: https://ssrn.com/abstract=3346477 or http://dx.doi.org/10.2139/ssrn.3346477

Christian Kubitza (Contact Author)

University of Bonn - Institute for Financial Economics and Statistics ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

Annette Hofmann

St. John's University - Peter J. Tobin College of Business ( email )

New York, NY
United States

Petra Steinorth

University of Hamburg - Institute for Risk Management and Insurance ( email )

Moorweidenstr. 18
Hamburg, 20148

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