Probability weighting and insurance demand in a unified framework

Abstract

We provide a comprehensive analysis of the impact of probability weighting on optimal insurance demand in a unified framework. We identify decreasing relative overweighting as a new local condition on the probability weighting function that is useful for comparative static analysis. We discuss the effects of probability weighting on coinsurance, deductible choice, insurance demand for low-probability, high-impact risks versus high-probability, low-impact risks, and insurance demand in the presence of nonperformance risk. Probability weighting can make better or worse predictions than expected utility depending on the insurance demand problem at hand.

Abandoning disaster relief and stimulating insurance demand through premium subsidies

“…Following Jaspersen et al (2022), the optimal insurance demand for iso-elastic utility functions is given by: *…”

“…He shows that the pattern in insurance demand that he observes can either be explained by discounting learning experiences over time or by lack of prior information. Jaspersen et al (2022) show that individuals who overestimate probabilities buy more insurance. Similarly, Collier et al (2022) demonstrate how overestimation of small probabilities can explain unexpectedly high insurance demand.…”

“…We follow other analyses of insurance demand such as Mossin (1968) or Jaspersen et al (2022) and derive an upper bound loading factor $$\bar{\lambda }$$ as well as a lower bound loading factor $$\mathop{\lambda }\limits_{\unicode{x000AF}}$$ to study the effect of charity hazard on insurance demand. It holds that for any $$\lambda \ge \bar{\lambda }$$, individuals do not buy any insurance $$({\alpha }^{* }=0)$$.…”

Probability weighting in commodity futures markets

“…Wang et al (2021) and Yu et al (2022) show that prospect theory can be used to understand foreign share returns and mutual fund performance respectively. Probability weighting also explains the insurance demand (Jaspersen et al, 2022) and the household portfolio underdiversification (Dimmock et al, 2021). Another recent strand of studies stresses the implications of the prospect theory in derivative markets, including the presence of anchoring in option prices (DeLisle et al, 2017), the puzzlingly low returns on the out-of-the-money (OTM) index options and the high variance premium (Baele et al, 2019), the covered call strategy returns (Nardon & Pianca, 2017), and the overpricing of the OTM individual stock calls (Félix et al, 2019).…”

Parametric Insurance—A Possible and Necessary Solution to Insure the Earthquake Risk of Romania

“…Despite the advantages of this product, the demand for parametric insurance products is lower than expected. Explaining this situation is an important topic in recent literature (Clarke 2016;Peter and Ying 2020;Jaspersen et al 2022).…”