Insurance decisions under nonperformance risk and ambiguity

Timo R Lambregts,Han Bleichrodt,Paul Van Bruggen

doi:10.1007/s11166-021-09364-7

Abstract

An important societal problem is that people underinsure against risks that are unlikely or occur in the far future, such as natural disasters and long-term care needs. One explanation is that uncertainty about the risk of non-reimbursement induces ambiguity averse and risk prudent decision makers to take out less insurance. We set up an insurance experiment to test this explanation. Consistent with the theoretical predictions, we find that the demand for insurance is lower when the nonperformance risk is ambiguous than when it is known and when decision makers are risk prudent. We cannot attribute the lower take-up of insurance to our measure of ambiguity aversion, probably because ambiguity attitudes are richer than aversion alone.

Highlights

The motivation for this paper is an important puzzle in insurance economics: why do people take out too little insurance against risks with potential huge consequences, such as natural disasters and long-term care needs
Bayesian testing shows support for the hypothesis that the proportion of risk averse choices is correlated with the loss probability ( Bayes factor (BF) = 5.7 ) and very strong support for the hypothesis that the proportion of ambiguity averse choices is correlated with the loss probability ( BF = 50.9)
Our main conclusion is that an ambiguous nonperformance risk leads to a reduction in insurance demand compared to a known nonperformance risk

Summary

Introduction

The motivation for this paper is an important puzzle in insurance economics: why do people take out too little insurance against risks with potential huge consequences, such as natural disasters and long-term care needs. During the COVID-19 pandemic, insurers across the globe have been hesitant to pay out claims for business interruption insurance and there is a fair amount of ongoing litigation about whether lost business income due to lockdowns is covered or not Concerns about such nonperformance may be grave when benefits occur in the far future, which carries the risk that insurers may go bankrupt, and which makes the value of insurance inherently more risky and ambiguous.. An individual’s choice whether to buy insurance can be schematically depicted as in Fig. 1.In the special case of full insurance, insurance with nonperformance risk is equivalent to Ehrlich and Becker’s (1972) concept of self-protection ( called prevention): both reduce the risk of incurring a loss, but they do not completely remove it.. Most of the literature on self-protection is about the level of effort. Denuit et al (2016) show, that the same difficulties that have been identified to choice of the optimal level of self-protection apply to the binary choice between two levels of self-protection

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