Loss Aversion Leads to Fatalistic Management of Interdependent Risk

Abstract

This paper studies risk management decisions for interdependent risk potentially causing catastrophic losses, against which agents typically self-protect (for example, natural catastrophes, cyber risks, pandemic risks). Our model reflects utility loss aversion and interdependent risk, a combination that—to the best of our knowledge—has not been examined in the literature, but is increasingly relevant in an interconnected world. We find that agents with self-protection as a reference point do not invest in other risk management activities, providing support for a fatalistic behavior observed in some insurance markets. This result holds for low and high levels of dependence. The higher the degree of loss aversion, the lower is the likelihood to invest in other risk management activities is when self-protection is implemented. Our results help to explain the lack of demand for catastrophe insurance or cyber risk insurance and have important implications for corporate risk management and public policy.

Keywords: Utility loss aversion, Self-protection, Self-insurance, Interdependent risk, Catastrophic event