Insurance and Probability Weighting Functions

University of Leicester, Working Paper Series No. 05/19

22 Pages Posted: 12 May 2008

See all articles by Ali al-Nowaihi

Ali al-Nowaihi

University of Leicester - Department of Economics

Sanjit Dhami

University of Leicester

Date Written: September 2006

Abstract

Evidence shows that (i) people overweight low probabilities and underweight high probabilities, but (ii) ignore events of extremely low probability and treat extremely high probability events as certain. Decision models, such as rank dependent utility (RDU) and cumulative prospect theory (CP), use probability weighting functions. Existing probability weighting functions incorporate (i) but not (ii). Our contribution is threefold. First, we show that this would lead people, even in the presence of fixed costs and actuarially unfair premiums, to insure fully against losses of sufficiently low probability. This is contrary to the evidence. Second, we introduce a new class of probability weighting functions, which we call higher order Prelec probability weighting functions, that incorporate (i) and (ii). Third, we show that if RDU or CP are combined with our new probability weighting function, then a decision maker will not buy insurance against a loss of sufficiently low probability; in agreement with the evidence. We also show that our weighting function solves the St. Petersburg paradox that reemerges under RDU and CP.

Keywords: Decision making under risk, Prelec¿s probability weighting function, Higher order Prelec probability weighting functions, Behavioral economics, Rank dependent utility theory, Prospect theory; Insurance, St. Petersburg paradox.

JEL Classification: D60, D81

Suggested Citation

al-Nowaihi, Ali and Dhami, Sanjit, Insurance and Probability Weighting Functions (September 2006). University of Leicester, Working Paper Series No. 05/19, Available at SSRN: https://ssrn.com/abstract=1130812 or http://dx.doi.org/10.2139/ssrn.1130812

Ali Al-Nowaihi (Contact Author)

University of Leicester - Department of Economics ( email )

Department of Economics
Leicester LE1 7RH, Leicestershire LE1 7RH
United Kingdom

Sanjit Dhami

University of Leicester ( email )

Department of Economics
Leicester LE1 7RH, Leicestershire LE1 7RH
United Kingdom

HOME PAGE: http://www2.le.ac.uk/departments/economics/people/sdhami

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