Risk Preferences and Demand Drivers of Extended Warranties

The objective of this paper is to understand the drivers of consumer choice under risk. We disentangle and study the relative importance of di erent preferences in explaining the high risk premia consumers pay for actuarially unfair insurance. Empirical and behavioral research on insurance is at odds on whether diminishing returns (curvature of the utility function), or loss aversion and non-linear probability weighting lead to the observed consumer behavior under risk. This is primarily due to the inability of standard choice data to separate curvature of the utility function, loss aversion and non-linear probability weights, and the need to rely on strong assumptions. We design a conjoint experiment with choices over washing machines (with and without warranty) where failure probabilities and repair costs are given to subjects. Using stated choice data from the survey, consumer preferences, degree of curvature, loss aversion and probability weights can be non-parametrically identi ed. We nd that loss aversion is signi cantly more important than curvature and probability weights in explaining product insurance choices. Importantly, failure to decompose risk averse behavior into that arising from curvature, loss aversion and probability weighting leads to lower washer and warranty prices, and under predicts the rate of change of warranty prices with varying repair costs. We nd substantial heterogeneity in product and risk preferences, but subjects, on average, have a linear utility function, are roughly twice as sensitive to losses as to gains of similar magnitude and non-linearly account for failure probabilities. The ndings are robust to di erent speci cations of the utility function and risk preferences. A model allowing for reference dependent preferences ts the data better than the expected utility model. Finally, not accounting for loss aversion, subjects have a lower willingness to pay for the washer and seem to get additional consumption utility from buying warranties.