Reference-Dependent Preferences and Insurance Demand

This article applies reference-dependent preferences to analyze insurance demand. Under the framework of Koszegi and Rabin (2006), we set up a model with two states of the world and the price of insurance is actually fair. We first assume that consumption utility is linear and demonstrate that the propensity to take up insurance is increasing with the loss probability. This finding explains the puzzle that people are not willing to take up subsidized disaster insurance but want to take up insurance for modest risk at highly loaded premiums. In the extreme cases, everyone will buy insurance for almost certain loss at fair premium but nobody will pay fair premium to buy insurance for nearly impossible loss events. To make the expositions more general, we relax the consumption utility to be quadratic and get similar results by numerical analysis. The relation between people's insurance demand and their risk types are also illustrated in this article.