WP 2015-10 Evaluating the Expected Welfare Gain from Insurance

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Published in 2016 in The Journal of Risk and Insurance, Volume 83, Issue 1.

ABSTRACT: Economic theory tells us how to evaluate the expected welfare gain from insurance products on offer to individuals. If we know the risk preferences of the individual, and subjective beliefs about loss contingencies and likelihood of payout, there is a certainty equivalent of the risky insurance policy that can be compared to the certain insurance premium. This simple logic extends to non-standard models of risk preferences, such as those in which individuals exhibit “optimism” or “pessimism” about loss contingencies in their evaluation of the risky insurance policy. We illustrate the application of these basic ideas about the welfare evaluation of insurance policies in a controlled laboratory experiment. We estimate the risk preferences of individuals from one task, and separately present the individual with a number of insurance policies in which loss contingencies are objective. We then estimate the expected consumer surplus gained or foregone from observed take-up decisions. There is striking evidence of foregone expected consumer surplus from incorrect take-up decisions. Indeed, the metric of take-up itself, widely used in welfare evaluations of insurance products, provides a qualitatively incorrect guide to the expected welfare effects of insurance.