Demand for fixed-price multi-year contracts: Experimental evidence from insurance decisions

Abstract

Do individuals prefer a fixed-price multi-year insurance (MYI) policy to current annual contracts with fluctuating prices? If so, are they willing to pay more for these policies? In a web-based 2-period repeated game with significant real money at stake, individuals have an opportunity to purchase 1-period insurance contracts, 2-period contracts or no insurance against the risk of a hurricane causing damage to their property. When premiums for both insurance options are actuarially fair, more than five times as many people favor the 2-period contract over the 1-period contract. The demand for a 2-period contract remains high even with a loading cost of 5% and 10% while keeping the 1-period premium actuarially fair, indicating a preference for stable premiums over time. These findings support the need for multi-year contracts that will lead more individuals to be adequately protected against future extreme events, given the empirical evidence on lack of interest in insurance against catastrophic risks. KeywordsIndividual decision-making, choice under uncertainty, multi-year insurance, disaster THE WHARTON RISK MANAGEMENT AND DECISION PROCESSES CENTEREstablished in 1984, the Wharton Risk Management and Decision Processes Center develops and promotes effective corporate and public policies for low-probability events with potentially catastrophic consequences through the integration of risk assessment, and risk perception with risk management strategies. Natural disasters, technological hazards, and national and international security issues (e.g., terrorism risk insurance markets, protection of critical infrastructure, global security) are among the extreme events that are the focus of the Center's research.The Risk Center's neutrality allows it to undertake large-scale projects in conjunction with other researchers and organizations in the public and private sectors. Building on the disciplines of economics, decision sciences, finance, insurance, marketing and psychology, the Center supports and undertakes field and experimental studies of risk and uncertainty to better understand how individuals and organizations make choices under conditions of risk and uncertainty. Risk Center research also investigates the effectiveness of strategies such as risk communication, information sharing, incentive systems, insurance, regulation and public-private collaborations at a national and international scale. From these findings, the Wharton Risk Center's research team -over 50 faculty, fellows and doctoral students -is able to design new approaches to enable individuals and organizations to make better decisions regarding risk under various regulatory and market conditions. The Center is also concerned with training leading decision makers. It actively engages multiple viewpoints, including top-level representatives from industry, government, international organizations, interest groups and academics through its research and policy publications, and through sponsored seminars, roundtables and forums.More information...

Economic Experiments, Hypothetical Surveys and Market Data Studies of Insurance Demand Against Low‐probability/High‐impact Risks: A Systematic Review of Designs, Theoretical Insights and Determinants of Demand

“…Solutions to overcome low uptake of insurance against LPHI risks have been studied, including offering multi‐year insurance which has fixed annual premiums each year and does not permit cancellations at the end of any given year. In theory, risk averse individuals should prefer the price stability of multi‐year policies compared to annual contracts which are subject to yearly price fluctuations (Kleindorfer et al ., ), which is supported by the experimental studies by Papon () and Kunreuther and Michel‐Kerjan ().…”

“…At least one study treatment must include a decision about a LPHI event. Low probability is defined here as equal to or below 0.05, which is consistent with experiments framed in the context of catastrophic risk (Kunreuther and Michel‐Kerjan, ). Moreover, this value is close to the highest yearly probability of suffering damage from typical low‐probability events like a flood, hurricane and earthquake.…”

“…Of the reviewed studies, Schade et al . (), Kunreuther and Michel‐Kerjan () and Zimmer et al . () incorporate such payments.…”

Determinants of Probability Neglect and Risk Attitudes for Disaster Risk: An Online Experimental Study of Flood Insurance Demand among Homeowners

“…Our investigation of incentives is secondary to the psychological and subjective factors highlighted in Section 2.1, although we find it an important topic due to the growing number of insurance demand studies using similar experiment procedures to ours (e.g., Kunreuther & Michel‐Kerjan, ; Schade et al., ; Zimmer, Gründl, Schade, & Glenzer, ). Common practice in experimental economics is to provide incentives that align experimental choices with incentives faced in actual market decisions (Camerer & Hogarth, ).…”

“…Therefore, we define zero willingness‐to‐pay for flood insurance as probability neglect of flood risk. Probability neglect has also been cited as a standard explanation for the refusal to protect oneself against disaster risks (e.g., Kunreuther & Michel‐Kerjan, ). In addition, we will investigate factors influencing individuals’ risk preferences according to their maximum willingness‐to‐pay for flood insurance values, while we recognize that these values do not separate risk attitudes due to either probability weighting or outcome sensitivity.…”