A prospect theory approach to assessing changes in parameters of insurance contracts with an application to money-back guarantees

Abstract

Prospect theory has changed the way economists think about decision making under uncertainty – yet after so many years there have been few applications of the theory and those appearing mostly in finance. One of the barriers to applying the prospect theory is that it is not designed to be applicable (Barberis, 2013). This study applies prospect theory to the selection of money back guarantee (MBG) contracts. When consumers can choose from a menu of MBG contracts they are basically trading off risk with price in a way that resembles a choice of lotteries with multidimensional outcomes. Our application, which integrates reference based utility models with elements of prospect theory and the disappointment model, helps in explaining the large premium attached to MBG contracts that cannot be explained by the expected utility framework. We further show that the combination of probability weighting with disappointment aversion appears to provide a better explanation for consumers’ high valuation of MBGs relative to each one when measured separately. We empirically test how consumers’ valuation of the MBG option is affected by MBG duration, variation in the likelihood of returns, and return conditions that affect consumers’ return cost. Our approach can be applied to model choices of risk reduction mechanisms such as extended warranties, demonstrations, and sampling.