Ambiguity Aversion and Wealth Effects on Demand for Insurance

Risk aversion and decreasing absolute risk aversion play prominent roles in the expected utility theory of demand for insurance against a known risk of accident losses. Demand for insurance against an accident risk that is not known with certainty depends on the attitude toward bearing this ambiguity as well as the underlying risk. Ambiguity aversion in the recursive model developed by Klibanoff et al. (2005) reinforces risk aversion in expected utility, increasing demand for insurance when pricing is not actuarially fair. However, greater ambiguity aversion does not necessarily result in a further increase in demand for insurance. Demand increases when possible accident risks can be ranked by the monotone likelihood ratio order, which is necessarily true for oneloss accidents. Under this ordering, ambiguity aversion also reinforces decreasing absolute risk aversion if preferences satisfy nonincreasing absolute ambiguity aversion. However, it is otherwise possible for insurance to be inferior in the absence of ambiguity, but normal in its presence, and vice versa.