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Study on the Irrational Behavior of Catastrophe Insurance Demand

Author: WangXianMin
Tutor: ZhaoZhengTang
School: Xiamen University
Course: Insurance
Keywords: the US flood insurance irrational behavioral economics
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Type: Master's thesis
Year: 2014
Downloads: 7
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Abstract


By now many countries have formed their own catastrophe insurance system suitable to their own situation. However, there is always market failure during the development of catastrophe insurance, such as the supply and demand falling short of people’s expectation or being irrational, which hinders the development of catastrophe insurance greatly.This paper analyzes irrational behaviors that lead to market failures from the angle of demand of catastrophe insurance. The basis of traditional demand theory is expected utility under the assumption of "perfect rationality" which is not quite in accordance with the real economic activities. According to theories of behavioral economics, the reason for insufficient demand for catastrophe insurance is that people become less risk-averse when faced with losses and they tend to take chances when the probability of losses is small. Besides, availability bias makes people give more weight to recent information and ignore earlier information, which leads to subjective estimate of risks.Based on this theory, this paper analyzes the latter irrationality taking American residents’ decision-making of buying flood insurance as an example. Firstly, this paper add the economics element "expectation" into traditional expected utility model, assuming residents’purchase of flood insurance is positively correlated with their expectation of the probability of flood, which is formed from earlier observation of flood and they update their "expectation" each time they observe a new flood. We introduce the Modified Beta-Bernoulli Bayesian Learning model during this process and regard people as forgetful and discount past information with rate " δ", which implies that newer information has larger influence on people’s decision-making.Then we use data from America to build a fixed-effect model to estimate the effect of damages caused by each flood on the policy purchases of catastrophe insurance. The result shows that flood catastrophe has a9-year declining effect on the demand for flood insurance, which confirms our analysis of residents’ irrational behavior.In the last, this paper tries to add behavioral economics element into the model when studying catastrophe insurance demand. For China, we can take advantage of this irrationality in catastrophe insurance to promote catastrophe insurance after disasters and build an efficient risk feedback mechanism to fully utilize government’s role in regulating the market.

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