Insurance demand in the presence of state dependent background uncertainty

Abstract

This paper considers the optimal demand for insurance in the presence of state dependent background uncertainty, that is, the uncertainty is dependent on the states which are clarified by the realization of the loss. First, we consider a situation in which the state dependent background risk is ordered by the stochastic dominance relation. When the background risk conditional on the loss state is worse (better) than the no-loss state, we determine the condition in which the insurance demand is higher (lower) compared with the state independent background risk.
Second, we consider a situation in which the uncertainty is different between the loss and the no-loss state. When ambiguity is introduced into the loss (no-loss) state, introducing ambiguity is higher (lower) compared with the risk case. Last, we discuss resolving the insurance demand puzzles by the different recognition of state dependent background uncertainty.

Keywords: Ambiguity aversion, Puzzle, State dependent background uncertainty, Stochastic dominance

JEL Classification: D81, D91, G22