|Essays on loss aversion and household portfolio choice.
|Year of Publication
|University of Illinois - Urbana-Champaign
|Older Adults, Portfolios, Risk Aversion
This dissertation studies how loss-aversion, i.e., people's behavioral tendency to be more sensitive to potential losses than the same amount of potential gains, affects households' insurance buying decisions and savings decisions. The first chapter, "Prospect Theory and Insurance Demand," tries to answer the question of why a substantial fraction of households remains uninsured even if classical expected utility theory predicts that it is beneficial to own insurance. This chapter posits that prospect theory's loss-aversion and reference point dependence can address the under-insurance puzzle and tests the theory. This chapter finds empirical evidence consistent with prospect theory using the American Life Panel (ALP) data: loss-averse individuals have a low ownership rate of long-term care insurance, supplemental disability insurance, and private health insurance; they express a low willingness to pay for health insurance; they are unwilling to purchase health insurance in a hypothetical insurance choice experiment. These results are consistent with prospect theory, which predicts that loss-aversion may decrease insurance demand if individuals' reference points are 'the wealth level when they do not engage in insurance contracts.' Under such reference points, individuals may regard insurance as a "risky investment" because they may lose premiums if a pre-specified bad event does not occur. Hence, those who are more sensitive to potential losses in premiums are unwilling to buy insurance. The second chapter investigates how loss-aversion affects individuals' decisions about saving using the Health and Retirement Study (HRS) data. Specifically, this chapter empirically tests if prospect theory's loss aversion decreases insurance demands and increases savings demands. Loss-averse individuals may be unwilling to buy term-life insurance because term-life insurance can be regarded as a risky investment. Instead, they may choose a more safe option to prepare for uncertain future events by increasing precautionary saving. This chapter tests this prediction and finds empirical evidence consistent with it: loss-averse individuals are less likely to own term-life insurance and more likely to own whole-life insurance, which serves as a partial savings instrument. These individuals also hold a higher level of wealth than others, suggesting that they tend to save more (presumably for precautionary motives), all other things being equal. The third chapter explores the socially optimal level of insurance given that households are subject to behavioral biases, especially narrow framing and loss aversion. The central issue of this normative analysis is whether or not a social welfare function (SWF) should take into consideration the behavioral components of preferences. One school of thought claims that social planners should not consider behavioral components since they are anomalies or mistakes that are often self-destructive. Another school of thought argues that social planners should respect behavioral components because… Advisors/Committee Members: Brown, Jeffrey R (advisor), Miller, Nolan H (advisor), Brown, Jeffrey R (Committee Chair), Miller, Nolan H (Committee Chair), Molitor, David (committee member), Weisbenner, Scott J (committee member).