Journal of Risk and Uncertainty

, Volume 15, Issue 1, pp 7–28 | Cite as

Probabilistic Insurance

  • PETER WAKKER
  • RICHARD THALER
  • AMOS TVERSKY
Article

Abstract

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.

probabilistic insurance decision weights prospect theory 

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  1. Borch, K. (1974). “The Mathematical Theory of Insurance.” Lexington, MA: Lexington Books.Google Scholar
  2. Camerer, C.F., and T.-H. Ho. (1994). “Violations of the Betweenness Axiom and Nonlinearity in Probability,” Journal of Risk and Uncertainty 8, 167–196.Google Scholar
  3. Chew, S.H., and L.G. Epstein. (1989). “The Structure of Preferences and Attitudes towards the Timing of the Resolution of Uncertainty,” International Economic Review 30, 103–117.Google Scholar
  4. Kahneman, D., and A. Tversky. (1979). “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47, 263–291.Google Scholar
  5. Loomes, G., and R. Sugden. (1986). “Disappointment and Dynamic Consistency in Choice under Uncertainty,” Review of Economic Studies 53, 271–282.Google Scholar
  6. Luce, R.D., and D. von Winterfeldt. (1994). “What Common Ground Exists for Descriptive, Prescriptive and Normative Utility Theories,” Management Science 40, 263–279.Google Scholar
  7. Merton, R.L. (1971). “Optimum Consumption and Portfolio Rules in a Continuous-Time Model,” Journal of Economic Theory 3, 373–413.Google Scholar
  8. Merton, R.C. (1993). “Operation and Regulation in Financial Intermediation: A Functional Perspective.” InP. Englund (Ed.), Operation and Regulation of Financial Markets, 17–68, The Economic Council, Stockholm.Google Scholar
  9. Mossin, J. (1968). “Aspects of Rational Insurance Purchasing,” Journal of Political Economy 76, 553–568.Google Scholar
  10. Prelec, D. (1995). “The Probability Weighting Function,” Econometrica, forthcoming.Google Scholar
  11. Quiggin, J. (1981). “Risk Perception and Risk Aversion among Australian Farmers,” Australian Journal of Agricultural Economics 25, 160–169.Google Scholar
  12. Schmeidler, D. (1989). “Subjective Probability and Expected Utility without Additivity,” Econometrica 57, 571–587.Google Scholar
  13. Segal, U. (1988). “Probabilistic Insurance and Anticipated Utility,” Journal of Risk and Insurance 55, 287–297.Google Scholar
  14. Segal, U. (1990). “Two-Stage Lotteries without the Reduction Axiom,” Econometrica 58, 349–377.Google Scholar
  15. Segal, U., and A. Spivak (1990). “First-Order versus Second-Order Risk-Aversion,” Journal of Economic Theory 51, 111–125.Google Scholar
  16. Tversky, A., and D. Kahneman (1992). “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Journal of Risk and Uncertainty 5, 297–323.Google Scholar
  17. Tversky, A., and P.P. Wakker (1995). “Risk Attitudes and Decision Weights,” Econometrica 63, 1255–1280.Google Scholar
  18. Viscusi, W.K. (1995). “Government Action, Biases in Risk Perception, and Insurance Decisions,” Geneva Papers in Risk and Insurance Theory 20, 93–110.Google Scholar
  19. Wu, G., and R. Gonzalez (1996). “Curvature of the Probability Weighting Function,” Management Science 42, 1676–1690.Google Scholar

Copyright information

© Kluwer Academic Publishers 1997

Authors and Affiliations

  • PETER WAKKER
    • 1
    • 2
  • RICHARD THALER
    • 3
    • 4
  • AMOS TVERSKY
    • 5
  1. 1.CentERTilburg UniversityTilburgThe Netherlands
  2. 2.Medical Decision Making UnitLeiden UniversityLeidenThe Netherlands
  3. 3.Graduate School of BusinessUniversity of ChicagoChicagoUSA
  4. 4.National Bureau of Economic ResearchCambridge
  5. 5.Stanford UniversityStanford

Personalised recommendations