Risk-averse Individuals Research Articles

The Unaccounted Insurance Value of Medical Innovation

Traditional value of medical innovation models estimate the benefits of a new treatment to individuals who fall sick ex-post. However, economic theory suggests medical innovation has additional benefits ex-ante - before susceptible individuals know whether or not they will fall sick. This paper presents a model for estimating the ex-ante value of new medical innovation, where risk-averse individuals who are susceptible to contracting a disease in the future derive value from the existence of a treatment, because risk-averse individuals prefer to insure against uncertainty in future survival outcomes. A healthy, risk-averse individual should value a new treatment for a disease and be willing to pay a small premium for it, even if he never uses it because of his future risk of the disease. I demonstrate that when individuals are risk-averse, the total ex-ante value is always greater than the total ex-post value. The difference between ex-ante and ex-post value is the insurance value of medical innovation due to risk aversion. I show that insurance value is highest for rare diseases, where afflicted patient populations are small, but vulnerable patient populations are large. For very rare diseases, up to 64 percent of the value of a cure is ex-ante insurance value. Using population-level estimates of disease risk for cancer, I find that between 24 and 63 percent of the value of cancer-specific cures are comprised of ex-ante insurance value - estimates vary by the prevalence and mortality risk of each cancer type. These results suggest there will be under-provision of valuable innovation by the private biopharmaceutical market if only ex-post valuations are reimbursed by payers.

Nucleus accumbens D2R cells signal prior outcomes and control risky decision-making.

A marked bias towards risk aversion has been observed in nearly every species tested. A minority of individuals, however, instead seem to prefer risk (repeatedly choosing uncertain large rewards over certain but smaller rewards), and even risk-averse individuals sometimes opt for riskier alternatives. It is not known how neural activity underlies such important shifts in decision-making--either as a stable trait across individuals or at the level of variability within individuals. Here we describe a model of risk-preference in rats, in which stable individual differences, trial-by-trial choices, and responses to pharmacological agents all parallel human behaviour. By combining new genetic targeting strategies with optical recording of neural activity during behaviour in this model, we identify relevant temporally specific signals from a genetically and anatomically defined population of neurons. This activity occurred within dopamine receptor type-2 (D2R)-expressing cells in the nucleus accumbens (NAc), signalled unfavourable outcomes from the recent past at a time appropriate for influencing subsequent decisions, and also predicted subsequent choices made. Having uncovered this naturally occurring neural correlate of risk selection, we then mimicked the temporally specific signal with optogenetic control during decision-making and demonstrated its causal effect in driving risk-preference. Specifically, risk-preferring rats could be instantaneously converted to risk-averse rats with precisely timed phasic stimulation of NAc D2R cells. These findings suggest that individual differences in risk-preference, as well as real-time risky decision-making, can be largely explained by the encoding in D2R-expressing NAc cells of prior unfavourable outcomes during decision-making.

Risk sensitivity and assortment in social dilemmas

Uncertainty and risk are key features of many social dilemmas, where individual decisions are often made with imperfect knowledge and variance in outcomes. In this paper, we investigate the evolutionary dynamics of the well-known public goods game using a recently introduced modelling framework encapsulating risk-sensitive assortment. Here, the population of mobile agents playing the game is divided into fixed-sized interaction groups. Individuals are defined by a single genetic trait--a risk sensitivity trait--that guides their decision-making. This trait is mapped to a continuous range of investment levels and also provides a mechanism to guide mobility (migration) decisions. Detailed computational simulation experiments confirm the relationship between risk orientation, decision-making and mobility in the game. As the size of each group increases, assortment levels tend to decrease and risk-averse individuals tend to dominate the population. However, in many scenarios, there was high variance in the proportion of `cooperators' both in groups and between different groups, suggesting that risk-seeking behaviour is an emergent property of mobility induced positive assortment.

A Theory of Rational Demand for Index Insurance

Rational demand for index insurance products is shown to be fundamentally different to that for indemnity insurance products due to the presence of basis risk. In particular, optimal demand is zero for infinitely risk-averse individuals, and is nonmonotonic in risk aversion, wealth, and price. For a given belief, upper bounds are derived for the optimal demand from risk-averse and decreasing absolute risk-averse decision makers. A simple ratio for monitoring basis risk is presented and applied to explain the low level of demand for consumer hedging instruments as a rational response to deadweight costs and basis risk. (JEL D14, D81, G13, G22, Q14)

Behavioural Biases in Investment Decision Making: A Research Study on Loss Aversion Bias

The concept of Loss aversion bias was developed by Daniel Kahneman and Amos Tversky in 1979. It was first introduced as a part of Prospect Theory. By virtue of different experimental observations, it is established that People are averse to losses because losses loom larger than gains. It makes a common individual primarily as risk-averse. This is followed by the secondary observation that a common risk-averse individual has a demand of minimum double return for any amount placed at a risk. This is particularly because an individual feels a stronger impulse for losses than gains. An individual never wants to lose and so, there is always an additional risk premium when losses are apprehended as alternate outcome. Loss aversion bias is thus ever influencing emotional bias existing in investment decision-making process.

Risk Aversion, the Hand Rule, and Comparison between Strict Liability and the Negligence Rule

AbstractOne of the most important propositions in the economics of liability rules states that strict liability and the negligence rule are equivalent and first-best efficient if the standard of due care is set according to the Hand rule. This proposition hinges on the assumption that individuals are risk neutral. This paper considers this proposition with risk-averse individuals, and demonstrates that the proposition does not extend. In particular, the two liability rules are not equivalent, and the analysis compares the two liability rules in terms of utilitarian social welfare.

Expectation and cooperation in prisoner's dilemmas: The moderating role of game riskiness.

This paper investigated the effect of risk orientation, game riskiness, and expectation of cooperation on cooperation in one-shot prisoner's dilemmas (PD). Participants in pairs played PD games that varied on game riskiness such that for half of the games cooperation was more risky than defection (more risky games) while for another half cooperation was less risky (less risky games). They estimated how likely it was that the other player was going to cooperate (expectation of cooperation) before they made their cooperation/defection decision on each game. Supporting the Goal/Expectation Hypothesis, we replicated the effect that expectation of cooperation enhanced cooperation. We also found that risk-seeking individuals cooperated more in more risky games whereas risk-averse individuals cooperated more in less risky games. More importantly, we found that game riskiness moderated the effect of expectation of cooperation on cooperation. The positive effect of expectation of cooperation on cooperation was stronger for more risky games than for less risky games. Our results illustrated how the relation between expectation and cooperation as stipulated by the Goal/Expectation Hypothesis was moderated by riskiness of the situations.

Do migrants send remittances as a way of self-insurance?

How do risk preferences affect migrant remittance behaviour? Examination of this relationship has only begun to be explored. Using a tailored representative survey of 1,354 immigrants in the Greater Dublin Area, Ireland, we find a positive and significant relationship between risk aversion and migrant remittances. Risk-averse individuals are more likely to send remittances home and are, on average, likely to remit a higher amount, after controlling for a broad range of individual and group characteristics. The evidence we obtain, that more remittances are sent by riskaverse immigrants who face higher wage risks and to individuals with more financial resources, is consistent with self-insurance although we cannot, with our data, rule out other exchange motives.

Individual quality and personality: bolder males are less fecund in the hermit crab Pagurus bernhardus.

One explanation for animal personality is that different behavioural types derive from different life-history strategies. Highly productive individuals, with high growth rates and high fecundity, are assumed to live life at a fast pace showing high levels of boldness and risk taking, compared with less productive individuals. Here, we investigate among-individual differences in mean boldness (the inverse of the latency to recover from a startling stimulus) and in the consistency of boldness, in male hermit crabs in relation to two aspects of life-history investment. We assessed aerobic scope by measuring the concentration of the respiratory pigment haemocyanin, and we assessed fecundity by measuring spermatophore size. First, we found that individuals investing in large spermatophores also had high concentrations of haemocyanin. Using doubly hierarchical-generalized linear models to analyse longitudinal data on startle responses, we show that hermit crabs vary both in their mean response durations and in the consistency of their behaviour. Individual consistency was unrelated to haemocyanin concentration or spermatophore size, but mean startle response duration increased with spermatophore size. Thus, counter to expectations, it was the most risk-averse individuals, rather than the boldest and most risk prone, that were the most productive. We suggest that similar patterns should be present in other species, if the most productive individuals avoid risky behaviour.

Risk preferences, technology adoption and insurance uptake: A framed experiment

Despite the yield improvements associated with the adoption of new farming technologies and modern inputs, technology diffusion amongst small-scale farmers in developing countries is slow. In this context, given the inherently risky environments in which farmers in the developing world operate, poor households are thought to be caught in a risk-induced poverty trap; specifically, poorer households that are unable to insulate themselves from consumption risk avoid these risks by opting for lower return, lower risk agriculture, and thus do not benefit from technological innovation. Using a series of laboratory experiments in a South African setting, this paper examines whether the provision of a framed index insurance product induces individuals to opt into riskier but potentially more profitable activities. To do so, we use a simple gambling task with real monetary prizes to elicit subjects’ risk preferences. Elicited risk preferences are applied to the uptake of credit and insurance in a series of framed insurance simulation games. Experiment participants are small-scale and subsistence urban food growers. Overall, the results of the experiment lend empirical weight to the poverty-trap argument. Firstly, a high degree of risk aversion is evident among the sample. Secondly, risk-averse individuals are more likely to opt into traditional agriculture (reflected as traditional seeds in the experiment) and are less likely to use modern farming inputs that require financing (high-yield varieties) despite the availability of insurance. The results indicate that the provision of index insurance is not a panacea for the problem of promoting technology diffusion to small-scale farmers in the developing world, but that residual production risk and basis risk must be considered in the contract design.

The economic value of forests in supplying local climate regulation

Several authors have argued that forest ecosystems serve as a hedge against extreme climatic events at a local scale. Consequently, the local climate regulation ecosystem services provided by forests can be economically valued by evaluating the reduction (increase) in the insurance premium that risk-averse individuals are willing to pay when forest cover is marginally increased (reduced). This type of insurance value associated to forest ecosystems services is estimated to be USD 0.0733 per hectare of forest for Chilean farmers. The empirical framework proposed in this paper is useful and relevant for the cost-benefit analysis of natural resource conservation investments.

The Impact of Entrepreneurial Risk Aversion on Wages in General Equilibrium

One of the leading theories of entrepreneurship is that less risk averse individuals become entrepreneurs and more risk averse individuals become their employees. Kihlstrom and Laffont (1979) formalized this insight in an elegant and widely taught general equilibrium model. However, their model has not been further developed. A reason may be that their main comparative static result, that an economy-wide increase in risk aversion lowers the equilibrium wage, appeared to require the assumption that all agents had identical risk aversion index, throwing out their motivating insight and indicating that the model is intractable. In this note we prove this comparative static result on risk aversion and wages in general equilibrium, retaining agent heterogeneity in risk aversion and the endogenous division of agents into less risk averse entrepreneurs and more risk averse workers, without adding any assumptions not already in the original paper. Besides the intrinsic value of the result, we hope to increase the usefulness of the Kihlstrom and Laffont (1979) model for other researchers and to facilitate improvement in its exposition for the many graduate courses in which it is taught.

Policy-Making and the Adaptability of Informal Institutions

This article discusses several of the insights generated by a theory of the formation of relationships between heterogeneously risk-averse individuals who lack access to formal insurance. An example illustrates the policy relevance of the theory, and demonstrates a relationship between the emergence of entrepreneurship in developing economies and higher income inequality. Reducing aggregate risk is a strict Pareto improvement if relationships in the status quo are assumed to remain constant, but is shown to be particularly harmful for the most risk-averse individuals and to exacerbate inequality when the endogenous network response is taken into account: the least risk-averse individuals abandon their roles as informal insurers in favor of entrepreneurial partnerships.

Job-Security Provisions and Incomplete Markets

We analyze the effects of mandated severance payments in an economy with search and matching in the labor market, risk-averse individuals and imperfect insurance against shocks. Our model emphasizes a tension between efficient worker-firm bargains and consumption smoothing: a well-designed contract dictates a downward shift in entry wages to offset expected severance payments, and thus goes against having a smooth consumption path. As a result, we find that severance payments produce mostly negative welfare effects. There are large allocation and welfare effects in the absence of savings which limits the response of wages to severance payments. With savings, the impact on equilibrium allocations is considerably dampened, but the welfare losses remain substantial.

Individual Risk Preference and Sector Choice: Are Risk-Averse Individuals More Likely to Choose Careers in the Public Sector?

Prior research indicates that public employees are more risk averse than private employees. Little is known, however, about the causes of such differences. This study tries to examine the effects of the “self-select mechanism” and asks the following question: Do workers choose their sectors based on their risk preferences? Using data from the National Longitudinal Survey, this study finds that higher levels of risk aversion are predictive of a greater propensity to pursue careers in the public sector. Findings indicate that an individual’s risk preference is the key to his or her career choices. Managerial implications and suggestions are discussed.

Does patience matter in marriage stability? Some evidence from Italy

Time preferences can affect divorce probability by both affecting the quality of the match and affecting the spouses’ reactions to negative shocks. We analyse the relationship between time preferences and divorce decisions using data from the Italian Survey on Household Income and Wealth, which provides a measure of time preferences based on a hypothetical financial situation in which individuals have to decide how much money to give up in order to receive a certain amount of money immediately rather than in one year’s time. By controlling for a number of individual and family characteristics, we find that impatient individuals are more likely to experience divorce. The effect is robust to different specifications of our model and is not affected by reverse causality problems. We also find that the more risk averse individuals are, the less likely they are to experience divorce.

Strategic technology adoption and hedging under incomplete markets

Abstract We investigate the implications of technological innovation and non-diversifiable risk on entrepreneurial entry and optimal portfolio choice. In a real options model where two risk-averse individuals strategically decide on technology adoption, we show that the impact of non-diversifiable risk on the option timing decision is ambiguous and depends on the frequency of technological change. Compared to the complete market case, non-diversifiable risk may accelerate or delay the optimal investment decision. Moreover, strategic considerations regarding technology adoption play a central role for the entrepreneur’s optimal portfolio choice in the presence of non-diversifiable risk.

Occupational Choice Under Credit and Information Constraints

Credit and information constraints can affect not only participation levels in different occupations, but also the types of individuals found in those occupations. I develop a model of occupational choice which shows how new information alters expectations and thus occupational choice. Credit and information constraints also interact with each other: the same information can have opposing impacts on occupational choice depending on the presence of credit constraints. Using a survey and information experiment in seven vocational high schools in Egypt, I find support for the model’s predictions, including a key compositional prediction: risk averse individuals respond more to changes in expectations of risk at both the intensive (variance of income) and extensive (probability of finding a job) margins. This differential response leads highly risk averse individuals to shift towards safer occupations on average, and out of using credit to start a small enterprise. Because those who are risk averse report lower returns to credit in general (by favoring lower risk/lower return investments), the average expected income for those utilizing credit rises by 12% relative to the no information case. I discuss other areas where information interventions may influence participation in, and thus the efficacy of, complementary policies.

Differences in anxiety sensitivity and sensation-seeking in relation to risk-taking on the Balloon Analogue Risk Task (BART)

Risk is an important factor impacting financial decisions. Risk can be processed objectively, e.g. as variance across possible outcomes of a choice option or subjectively, e.g. as value of that variance to a given individual. The aim of the present study was to test the potential of functional near-infrared spectroscopy (fNIRS) in assessing these different ways of processing risk while subjects decided between either high or low risk financial options or a safe (risk-free) option. For comparison we simultaneously measured electrodermal activity (EDA), a well-established method in decision-making research and a core measure of affective processes. FNIRS showed that lateral prefrontal cortex responses to high risk were enhanced relative to low risk only in risk-seeking individuals but reduced relative to low risk in risk-averse individuals. This is in-line with individual-specific risk processing reflecting the subjective value of risk. By contrast, EDA showed enhanced responses to high risk, independent of individual risk attitude, in-line with the notion of objective risk processing. The dissociation between the two measures arose even though they overall were equally sensitive to detect individual risk-related differences and even though there was an increased, risk attitude-independent, temporal coherence between the two measures during high-risk conditions. Our results suggest that hemodynamic responses in lateral prefrontal cortex as measured by fNIRS reflect the subjective value of risk, whereas EDA may index the objective amount of risk people are presented with. The findings suggest that fNIRS could be a useful method for studying risk behavior in financial decisions.

Too Risk Averse to Purchase Insurance? A Theoretical Glance at the Annuity Puzzle

This paper suggests a new explanation for the low level of annuitization, which is valid even if one assumes perfect markets. We show that, as soon there exists a positive bequest motive, suciently risk averse individuals should not purchase annuities. A model calibration accounting for lifetime risk aversion generates a willingness-to-pay for annuities, which is significantly smaller than the one generated by a standard Yaari (1965) model. Moreover, the calibration predicts that riskless savings finances one third of consumption, in line with empirical findings.