Kiel Working Papers, Kiel Institute for World Economics
No 1764:
Insurance Demand under Prospect Theory:A Graphical Analysis
Ulrich Schmidt
Abstract: This paper analyzes insurance demand under prospect theory
in a simple model with two states of the world and fair insurance
contracts. We argue that two different reference points are reasonable in
this framework, state-dependent initial wealth or final wealth after buying
full insurance. Applying the value function of Tversky and Kahneman (1992),
we find that for both reference points subjects will either demand full
insurance or no insurance at all. Moreover, this decision depends on the
probability of the loss: the higher the probability of the loss, the higher
is the propensity to take up insurance. This result can explain empirical
evidence which has shown that people are unwilling to insure rare losses at
subsidized premiums and at the same time take-up insurance for moderate
risks at highly loaded premiums
Keywords: insurance demand, prospect theory, flood insurance, diminishing sensitivity, loss, aversion; (follow links to similar papers)
JEL-Codes: D14,; D81,; G21; (follow links to similar papers)
11 pages, March 2012
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