WP 2017-03 Welfare Effects of Insurance Contract Non-Performance

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Forthcoming – The Geneva Risk and Insurance Review

ABSTRACT: Non-performance lies at the heart of much of the regulation that insurance companies face. Consumers’ concerns about non-performance of the insurance provider have also been cited as a possible explanation for low demand of microinsurance. We provide a behavioral evaluation of the welfare effects of non-performance risk. We test the hypothesis that the presence of non-performance risk negatively impacts not just take-up of insurance but more importantly the welfare of the insured. We also test if violations of the Reduction of Compound Lotteries axiom could drive this decrease in take-up and welfare. The results show that the compound risk characteristic of non-performance risk does not significantly decrease the welfare of insurance choices made by individuals. This counter-intuitive result is sensitive to the structural modeling of risk preferences. If one assumes the reduction of Compound Lotteries axiom does characterize behavior towards risk, one finds evidence that non-performance risk reduces welfare for the insured. But if one correctly allows for violations in that axiom in the representation of risk preferences, which is appropriate if one is going to test for the effect of compound risk from non-performance, then the counter-intuitive result is obtained. Take-up is not a reliable proxy for welfare, and the drivers of take-up are again not the same drivers of welfare. These results provide structural behavioral insight to inform normative policy design with respect to insurance regulation.