Insurance Demand under Prospect Theory: A Graphical Analysis

This paper analyzes insurance demand under prospect theory in a simple model with two

states of the world and fair insurance contracts. We argue that two different reference points

are reasonable in this framework, state-dependent initial wealth or final wealth after buying

full insurance. Applying the value function of Tversky and Kahneman (1992), we find that for

both reference points subjects will either demand full insurance or no insurance at all.

Moreover, this decision depends on the probability of the loss: the higher the probability of

the loss, the higher is the propensity to take up insurance. This result can explain empirical

evidence which has shown that people are unwilling to insure rare losses at subsidized

premiums and at the same time take-up insurance for moderate risks at highly loaded

premiums.

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