Prospect Theory and Insurance Demand

Abstract

This paper empirically tests if prospect theory’s loss-aversion and reference point dependence can explain individuals’ real-world insurance take-up behavior. This paper uses American Life Panel data and finds empirical evidence consistent with prospect theory: loss-averse individuals have a low ownership rate of long-term care insurance (LTCI), supplemental disability insurance (SDI), and private health insurance; they express a low willingness to pay for health insurance; they are unwilling to purchase health insurance in a hypothetical insurance choice experiment. These results are consistent with prospect theory, which predicts that loss-aversion may decrease insurance demand if individuals’ reference points are ‘the wealth level when they do not engage in insurance contracts.’ Under such reference points, individuals may regard insurance as a “risky investment” because they may lose premiums if a pre-specified bad event does not occur. Hence, those who are more sensitive to potential losses in premiums are unwilling to buy insurance. This paper also provides suggestive evidence that reference points are important in determining the relationship between loss-aversion and insurance demand by showing that the negative relationship between the two does not hold under a different reference point.