Rational Insurance Purchasing: Consideration of Contract Nonperformance

Abstract

Much of the analysis of rational insurance purchasing and hedging strategies has been undertaken on the basis of the expected utility hypothesis. This decision framework has been used to reformulate the Bernoulli principle that a risk averter rationally would fully insure at a fair premium. Other applications include the analysis of insurance at unfair premiums (Mossin [1968 ] and Smith [1968]), the effects of state-dependent utility on the rational insurance purchase (Cook and Graham [1977]), the effects of risky background wealth (Doherty and Schlesinger [1983] and Mayers and Smith [1983]), and the design of the optimal insurance policy (Raviv [1979] ). Such analyses have been conducted on the assumption that insurance policies are free of insolvency (default) risk. This assumption stands in sharp contrast to the actuarial literature in which the insolvency risk, or probability of ruin, is a central focus of attention.