WP 2022-02 The Welfare Consequences of Processing Compound Risk

AUTHORS: Glenn Harrison, Jimmy Martínez-Correa, Karlijn Morsink, Jia Min Ng, and Todd Swarthout

ABSTRACT: For consumers to make efficient financial decisions, the mapping of beliefs about probabilities of states of the world with potential outcomes is an important cognitive process. Many financial decisions, as a part of this mapping, require consumers to be able to process compound risk. This ability, and an individual’s potential violations of the Reduction of Compound Lotteries (ROCL) axiom could play an important role in explaining demand and welfare for these financial products. We investigate this link in the context of insurance with compound risk, and show that individuals who violate ROCL excessively purchase insurance, leading to welfare losses. However, when these ROCL violators are given a decision aid that helps them process compound risk, they purchase less insurance and do no worse in terms of welfare than individuals who do not violate ROCL. An important policy implication of our findings is that average consumer welfare should increase if providers of financial products such as insurance, pensions and warranties, are required to inform consumers, transparently, and in a balanced manner, about the compounded probabilities of all potential states that the product does and does not cover.