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Reference dependent risk preferences and insurance Demand

Toney, George Philip
Master thesis
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URI
https://hdl.handle.net/11250/2679809
Date
2020
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  • Master Thesis [3258]
Abstract
This thesis explores insurance decisions with respect to modest risks. Bernoulli’s expected

utility theory is compared to a model where utility depends on both final wealth and changes in

wealth relative to some reference point. Optimal insurance is derived within these frameworks.

An important result in the expected utility theory is that full insurance is only optimal at

actuarially fair premia. I show that when utility also depends on some reference point, full

insurance may be optimal at unfair premia and no insurance may be optimal at fair premia. The

aim of the study is to investigate which model is best suited to explain preferences over smallscale insurance contracts. The analysis is based on a survey experiment of 904 Norwegian

citizens, representative of the general population, in the spring of 2020. The respondents were

asked to choose between hypothetical income gambles and menus of small-scale insurance

contracts. The results display strong indications that the reference dependent model is superior

to expected utility theory when predicting insurance choices. The majority of the sample made

insurance choices that can be explained by the reference dependent model, whereas only seven

percent made choices that are in line with expected utility theory. There also appears to be high

heterogeneity in both the degree of risk aversion and in people’s reference points. Among those

respondents whose choices are in line with the reference dependent model, approximately half

seem to have full insurance as their reference point and prefer full insurance at unfair premia,

whereas the other half seem to have no insurance as their reference point and prefer no insurance

at fair premia.

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