The benchmark model of demand developed in Chapter 2, based on expected utility theory, postulates a world in which the collection and processing of relevant information is costless to consumers, risk is perceived accurately, and the individual is assumed capable of choosing the amount of insurance that maximizes his or her expected utility. As long as people are risk averse, they are willing to pay a premium greater than the expected value of losses from a set of prespecified risky events. The maximum amount an individual is willing to pay for a given level of coverage depends on that individual’s degree of risk aversion. The optimal amount of coverage is determined by comparing the benefits of more financial protection should a disaster occur with the additional premiums for purchasing this additional coverage.
In the last chapter, we explored extensions to the benchmark model of demand that introduced imperfect information and search costs, but maintained the assumption that individuals choose options that maximize their expected utility. This chapter further relaxes some of the benchmark model assumptions and explores different theories of choice and behavior under risk. As we will show, commonly observed behaviors inconsistent with expected utility maximization can be explained by other theories supported by data from experiments, field studies, and consumers’ actual insurance-related decisions.