Consumer insurance decisions: An empirical analysis of four real-world decisions

                         Austin, Laurel Cecelia; PhD

                         CARNEGIE-MELLON UNIVERSITY, 1996


                         This thesis presents an empirical study of four different, but related, real-world automobile insurance
                         decisions by 74 Pennsylvania drivers. Expected utility (EU) theory and innovation diffusion theory, two
                         theories proposed as describing insurance decisions, were tested. Cognitive psychology methods were
                         used to gather and examine verbal data, in order to compare subjects' mental models of the decision
                         problems to those theoretical models. These methods minimized imposing researchers' views of the
                         decision problem on subjects, something often unavoidable with other methodologies. Decisions
                         examined were whether to buy optional collision coverage, choice of deductible, what liability limits to
                         carry, and whether to take full or limited tort. Expected utility (EU) theory is the foundation of most
                         theoretical insurance research. Three well-accepted EU predictions relating insurance demand to risk
                         aversion, wealth, premium, and loss probability and magnitude were tested for each decision. Diffusion
                         theory, which predicts that knowing other innovation adopters increases a person's own probability of
                         adopting, was primarily tested with the tort decision. This study was largely designed as a constructive
                         replication of Kunreuther et al.'s (1978) study where a diffusion model predicted consumers' flood and
                         earthquake insurance decisions, but an EU model did not. Whether optional collision coverage was
                         carried was predicted by subjects' contingency-price ratios and liability coverage increased with wealth,
                         consistent with EU predictions. Neither decision was consistent with other EU predictions tested, and
                         deductible levels and tort decisions were not consistent with any of the EU predictions. Verbal reports
                         showed overlap between subjects' mental models and EU theory where that theory made successful
                         predictions and offered explanations for why other predictions were not observed. For example,
                         insurance coverage in general increases with wealth, contrary to the well-accepted EU prediction that
                         (property) insurance is an inferior good. More risk averse consumers did not purchase more insurance, as
                         EU theory predicts. Analysis of verbal data suggests that consumers' need to budget limited cash
                         resources in the short term explains these failures of EU theory, which treats insurance in isolation of
                         other consumption and assumes maximization of expected (long-term) utility. Diffusion theory did not
                         describe decisions regarding adoption of limited tort, a recent insurance innovation. Nor did it describe
                         decisions to drop collision coverage. Failure to replicate Kunreuther et al.'s findings may be because
                         consumers use different decision models for different insurance decisions and because they rely more
                         on insurance agents regarding automobile insurance than for hazard insurance.

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