(Over)insuring Modest Risks

Abstract

Despite the large literature on anomalies in risky choice, very little research has explored the relevance of these insights in real insurance markets. This paper uses new data on consumers' choices of deductibles for home insurance to provide evidence that a surprising level of risk aversion over modest stakes is a reality in the market. Most customers purchase low deductibles despite costs significantly above the expected value. Fitting these choices to a standard model of risk aversion yields implausibly large measures of risk parameters. Potential explanations and the implications of these results for understanding the market for insurance are discussed. (JEL D14, D81, G21, G22)

Consumers’ misunderstanding of health insurance

“…If simplifying insurance reduced these tendencies, it could potentially improve the quality of choices. Moreover, offering plans with copayments but no deductibles could help to remove one major source of suboptimality generally observed in choices among insurance plans -the tendency for consumers to choose plans with lower than optimal deductibles (Sydnor, 2010).…”

“…Almost surely, the single largest mistake that most insurance purchasers make is to purchase policies with overly low deductibles (Sydnor, 2010). Indeed, such mistakes are so severe that in some cases they violate dominance -e.g., when someone pays more than $250 to drop the deductible on a medical insurance policy by less than $250.…”

“…Given a significant core of naïve consumers, they show, a market equilibrium can arise in which naïve consumers pay prices substantially above marginal cost, and effectively subsidize sophisticated consumers who are able to exploit the mispricing. In the domain of insurance, for example, the existence of a substantial core of consumers who are disproportionately attracted to low deductible policies (see, e.g., Barseghyan et al, forthcoming;Sydnor, 2010) can enhance insurer's profits at the expense of those opting for low deductibles, while those who opt for high deductibles escape to fairly priced plans.…”

Risk Aversion, Loss Aversion, and the Demand for Insurance

“…These findings can help explain some empirical "anomalies" in risky choices that have been documented for some agents in real insurance markets, namely that people tend to over-insure against modest risks (Schmidt 2016) and that many customers purchase low deductibles despite costs exceeding expected losses (Sydnor 2010).…”

“…As pointed out by Sydnor (2010), insurance decisions are different from speculative gambles because their consequences are determined entirely in the loss domain. It is therefore questionable whether the status quo (corresponding to initial wealth without taking up insurance) could be an appropriate reference point for a two-argument utility model.…”