Working Paper
Insurance Demand under Prospect Theory: A Graphical Analysis
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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.
