Financial Literacy and Precautionary Insurance

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