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Representativeness and managing catastrophe risk

Abstract

The representative heuristic causes individuals to underweight prior probabilities and overweight posterior probabilities. We examine the effect of the representative heuristic on the demand for insurance and participation in mitigation activities. Pre-disaster, the representative heuristic leads to lower demand for insurance, even for a subsidized policy; indeed zero coverage may be optimal for a subsidized policy. After a disaster occurs, the heuristic causes individuals to demand more insurance than those not subject to the heuristic, even if policies are unfairly priced. We depict the subsidization needed prior to a disaster to induce individuals to purchase insurance and show the level of unfair pricing that can be tolerated post-disaster. Similarly, the heuristic causes individuals to have a lower willingness to pay for mitigation activities pre-disaster, relative to an individual not subject to the heuristic. Post-disaster the heuristic causes willingness to pay for mitigation to be higher.

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Notes

  1. 1.

    We do not address supply side issues in this paper although the supply of insurance for natural disasters is also unique and should be combined with the demand-side as analyzed here to have a full understanding of insurance for natural disasters.

  2. 2.

    The Online Resource provides derivations of equations (2) and (4).

  3. 3.

    We have also investigated the impact of the RH on the demand for insurance when there is a coinsurance policy. Similar results hold.

  4. 4.

    We also consider a continuous loss distribution. In this setting, the RH will alter the probability density function (pdf) of the loss, although much of the analysis for insurance demand depends on the value of cumulative distribution function (cdf) for the loss evaluated at zero. Irrespective of how the pdf changes, the cdf will equal zero at zero, so changes in the demand for insurance will not be captured effectively. We consider deductible policies with an exponential loss distribution where the expected loss for a RH individual is lower (higher) pre-disaster (post-disaster) than that estimated by a Bayesian individual. We obtain similar results: a RH individual will optimally choose lower coverage than a Bayesian individual pre-disaster, and post-disaster, he will optimally choose higher coverage.

  5. 5.

    By suggesting subsidization is needed to induce insurance demand pre-disaster, we do not consider the impact that subsidization would have on investment and development decisions in flood prone areas or the fact that subsidized insurance might lead to an inefficient use of land as shown by Krutilla (1966).

  6. 6.

    Please note that these weights will depend on the individual’s preferences and risk aversion. In these examples, we assume the difference in posterior and prior probabilities is the same as estimated in Grether (1980); therefore we implicitly show illustrative examples for those with preferences similar to subjects in that study.

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Correspondence to Jacqueline Volkman-Wise.

Additional information

The author is thankful to the editor, W. Kip Viscusi, and an anonymous referee for their helpful comments and suggestions. The author also thanks Hua Chen, J. David Cummins, Rob Drennan, Ralf Kellner, Howard Kunreuther, Henri Louberge, Erwann O. Michel-Kerjan, Olivia S. Mitchell, Greg Nini, Krupa Viswanathan, and participants at the Western Risk and Insurance Association conference, World Risk and Insurance Economics Congress, Financial Management Association conference, and Wharton IRM Seminar Series for their comments.

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Volkman-Wise, J. Representativeness and managing catastrophe risk. J Risk Uncertain 51, 267–290 (2015). https://doi.org/10.1007/s11166-015-9230-7

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Keywords

  • Disaster
  • Insurance demand
  • Catastrophic risks
  • Risk belief
  • Representative heuristic
  • Probability estimation

JEL Classification

  • D81
  • D83
  • G22