Topic14_Uncertainty

# 40 insurance for diversifiable risk insurance

• Notes
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Insurance for Diversifiable Risk Insurance companies know that although Insurance companies know that although single events are random and largely unpredictable, the average outcome of many similar events can be predicted. When insurance companies sell many policies (e.g., fire insurance, health insurance, etc.) or the same policy to many individuals (e.g., health insurance to all employees from many firms), they face relatively little risk by “ risk pooling” 41 pooling .
Behavioral Economics Many individuals make choices under Many individuals make choices under uncertainty that are inconsistent with the predictions of expected utility theory. Kahneman and Tversky (1979, 1981) have shown that some people’s choices vary with circumstances and contradicts with expected utility theory. Many people reverse their choices when a problem is framed in a different way. 42

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Behavioral Economics of Risk For example: If Program A is adopted, 200 people will be saved. If program B, then 600 people will be saved with 1/3 probability and none with 2/3 probability. When college students were asked to choose between above two programs, 72% opted certain gains of Program A over larger but riskier gains of Program B 43 riskier gains of Program B.
Behavioral Economics of Risk Another example: If Program C, 400 people will die. If program D 1/3 probability that no one If program D, 1/3 probability that no one will die and 2/3 probability that 600 people will die. When faced with this choice, 78% chose the larger but uncertain losses of program D over the certain losses of Program C. Note that both Programs A and C are the 44 same (200 die means 400 saved out of 600).

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Behavioral Economics of Risk Similarly B and D are also the same. As we can see in the case of gains (choice between A and B), people preferred certain gains over uncertain gains. On the other hand in the case of losses, people preferred uncertain losses over certain losses. Implications---the expected utility theory fails to predict people’s choices . 45
Behavioral Economics of Risk Certainty Effect : Many people put more weight on certain outcomes than on uncertain ones. In an experiment when people were presented the followings options, a vast majority chose B. Option A : \$4,000 with p = 0.8 and 0 with p = 0.2 and Option B : \$3,000 with certainty with certainty. In another experiment when the following two ti t d j it h C 46 options were presented, a majority choose C.

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Behavioral Economics of Risk Option C : \$4000 with p=0.2 and 0 with p = 0.8. : \$4000 with p 0.2 and 0 with p 0.8. Option D : \$3,000 with p=0.25 and 0 with p = 0 75 0.75. Choosing B over A U(3K) > 0.8U(4K) or U(3K)/U(4k) > 0 8 U(3K)/U(4k) 0.8. Choosing C over D 0.2U(4K) > 0.25U(3K) or U(3K)/U(4k) < 0 8 or U(3K)/U(4k) 0.8. The results are inconsistent with the Expected Utility Theory 47 Expected Utility Theory.
Behavioral Economics of Risk Prospect Theory developed by Kahneman developed by Kahneman and Tversky (1979) explain some of the choices people make that are inconsistent with Expected Utility theory.

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• Spring '10
• E.Fowler
• Utility, Ri, Behavioral Economics of Risk

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