Premium
I NSURANCE D EMAND U NDER P ROSPECT T HEORY : A G RAPHICAL A NALYSIS
Author(s) -
Schmidt Ulrich
Publication year - 2016
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/jori.12098
Subject(s) - function (biology) , economics , microeconomics , actuarial science , business , microbiology and biotechnology , biology
A BSTRACT This article 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 ([Tversky, A., 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 that 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.