Reference-Dependent Risk Attitudes

Kőszegi and Rabin (forthcoming) develop a model building from prospect theory that a) combines the reference-dependent “gain-loss utility” with standard “consumption utility,” b) bases the reference point on beliefs about outcomes rather than on the status quo, and, to incorporate probabilistic beliefs, c) allows for stochastic reference points. In this paper we develop an extension of that model, and apply both the original and the extension to study the taste for insurance and other preferences over monetary risk. The model predicts that the environment—through its effect on expectations—heavily influences risk attitudes toward modest-scale risk. When exposure to potential modest-scale changes in wealth is a surprise, the model corresponds to a form of classical prospect theory, and hence predicts a distaste for insuring surprise losses. When potential losses are anticipated, planned spending on insurance does not generate sensations of loss while uncertain bad outcomes do, leading to a very high willingness to pay for insurance. When there are risks a person cannot or does not want to avoid, insuring additional risks does not eliminate the possibility of painful loss, so her willingness to pay for insurance is reduced. The model also allows for consumption utility to dominate attitudes towards large-scale risks, predicting a general taste for insurance against large-scale risks independently of the environment.