Affective Decision Making in Insurance Markets

This paper suggests incorporating affective considerations into models of decision making and insurance decisions in particular. The model is based on, and explores the implication of, a distinction between two internal thinking processes. This distinction is supported by numerous studies in psychology, and is a formalization of what is often refered to as the dual processes theory. More specifically, the decision maker is modeled as having two internal accounts — the rational account and the mental account. In the context of insurance choice, the rational account decides on the insurance level that maximizes expected (perceived) utility, while the mental account chooses the risk perception that maximizes expected utility net of mental costs. In order to reach a decision, the two accounts interact. This interaction is modeled as an intrapersonal simultaneous move game. Choice is characterized by the pure strategy Nash equilibria of the game. Hence, choice is composed of both risk perception and insurance level and reflects consistency between the two accounts. This framework naturally separates between report and choice tasks. In addition, it captures framing (attentional) effects, and gives rise to both optimism and pessimism. In the insurance markets, the presence of affective considerations allows for negative correlation between objective risk and insurance level, and implies that the absolute risk aversion property of the utility function cannot be extracted from the data. Moreover, the mental account suggests a linkage between models of risk and uncertainty. JEL classification numbers: D14, D80, D81, G22, Z00