Probabilistic Insurance

Probabilistic insurance is an insurance policy involving a small probability that the consumer will not be reimbursed. Survey data suggest that people dislike probabilistic insurance and demand more than a 20% reduction in premium to compensate for a 1% default risk. These observations cannot be explained by expected utility in which the reduction in premium is approximately equal to the default risk, as we demonstrate under highly plausible assumptions about the utility function. However, the reluctance to buy probabilistic insurance is predicted by the weighting function of prospect theory. It appears that the purchase of insurance is driven primarily by the overweighting of small probabilities rather than by diminishing marginal utility.