Insurance Decisions under Ambiguity

Abstract

In this paper, I study the impact of ambiguity on insurance decisions and the optimality of insurance contracts. My tractable approach allows to study the interaction between risk and ambiguity attitudes. When insurance decisions are made independently of other assets, for a given increase in wealth, both risk and ambiguity attitudes interact in nontrivial ways to determine the change of coinsurance demand. I derive sufficient conditions to guarantee that the optimal coinsurance demand is decreasing in wealth. When a non-traded asset is introduced, my model predicts behavior that is inconsistent with the classical portfolio theory that assumes Subjective Expected Utility theory; however, it provides hints to a possible solution of the under-diversification puzzle of households. I also identify conditions under which more risk or ambiguity aversion decreases the demand for coinsurance. Additionally, I show a counterexample to a classical result in insurance economics where an insurance contract with straight deductible is dominated by a coinsurance contract. Finally, I find that a modified Borch rule characterizes the optimal insurance contract with bilateral risk and ambiguity attitudes and heterogeneity in beliefs.

Keywords: Insurance, Ambiguity Aversion, Non-traded Assets, Optimal Contracts.