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Probabilistic insurance is an insurance policy involving a small probability that the consumer will not be reimbursed. Survey data suggest that people dislike probabilistic insurance and demand more than a 20% reduction in the premium to compensate for a 1% default risk. While these preferences are intuitively appealing they are difficult to reconcile with expected utility theory. Under highly plausible assumptions about the utility function, willingness to pay for probabilistic insurance should be very close to willingness to pay for standard insurance less the default risk. However, the reluctance to buy probabilistic insurance is predicted by the weighting function of prospect theory. This finding highlights the potential role of the weighting function to explain insurance.
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- Probabilistic Insurance
Journal of Risk and Uncertainty
Volume 15, Issue 1 , pp 7-28
- Cover Date
- Print ISSN
- Online ISSN
- Kluwer Academic Publishers
- Additional Links
- probabilistic insurance
- decision weights
- prospect theory
- Industry Sectors
- Author Affiliations
- 1. CentER, Tilburg University, Tilburg, The Netherlands
- 2. Medical Decision Making Unit, Leiden University, Leiden, The Netherlands
- 3. Graduate School of Business, University of Chicago, Chicago, IL, 60637, USA
- 4. National Bureau of Economic Research, Cambridge, MA, 02139
- 5. Stanford University, Stanford, CA, 94305