Loss Modification Incentives for Insurers under Expected Utility and Loss Aversion

Tinbergen Institute Discussion Paper 14-111//VII

29 Pages Posted: 25 Aug 2014

See all articles by Adriaan R. Soetevent

Adriaan R. Soetevent

University of Groningen

Liting Zhou

University of Amsterdam - Amsterdam School of Economics (ASE); Tinbergen Institute

Date Written: August 20, 2014

Abstract

Given the possibility to modify the probability of a loss, will a profit-maximizing insurer engage in loss prevention or is it in his interest to increase the loss probability? This paper investigates this question. First, we calculate the expected profit maximizing loss probability within an expected utility framework. We then use Köszegi and Rabin's (2006, 2007) loss aversion model to answer the same question for the case where consumers have reference-dependent preferences. Largely independent of the adopted framework, we find that the optimal loss probability is sizable and for many commonly used parameterizations much closer to 1/2 than to 0. Previous studies have argued that granting insurers market power may incentivize them to engage in loss prevention activities, this to the benefit of consumers. Our results show that one should be cautious in doing so because there are conceivable instances where the insurer's interests in modifying the loss probability to against those of consumers.

Keywords: loss modification, expected utility, reference-dependent preferences, insurance

JEL Classification: D11, D42, D81, L12

Suggested Citation

Soetevent, Adriaan R. and Zhou, Liting, Loss Modification Incentives for Insurers under Expected Utility and Loss Aversion (August 20, 2014). Tinbergen Institute Discussion Paper 14-111//VII, Available at SSRN: https://ssrn.com/abstract=2484486 or http://dx.doi.org/10.2139/ssrn.2484486

Adriaan R. Soetevent (Contact Author)

University of Groningen ( email )

P.O. Box 800
9700 AV Groningen
Netherlands
++ 31 50 363 7018 (Phone)

HOME PAGE: http://www.soetevent.com

Liting Zhou

University of Amsterdam - Amsterdam School of Economics (ASE) ( email )

Roetersstraat 11
Amsterdam, North Holland 1018 WB
Netherlands

Tinbergen Institute ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

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