Risk Management Decisions in Low Probability and High Loss Risk Situations: Experimental Evidence

Most theoretical and empirical studies have consistently demonstrated that insurance markets for high probability events can be expressed by standard expected utility; however, the EUT is inadequate to explain decision making processes in low probability risk situations. The current study aims to investigate the way people make their insurance decisions in low probability and high loss contexts such as bankruptcy, insolvency, natural disasters etc. More specifically, we try to examine whether elicitation method (buying or paying) induces similar risk management decisions or not, and whether risk attitude and/or threshold probabilities affect the valuations. We test whether preference reversal exists and we elicit individuals’ threshold probabilities to explore prospective reference theory. The results indicate that subjects considered the probability of loss (the size of the loss) when they face buy or not decision (willingness to pay decision). In addition, the second-order stochastic dominance is supported, however, no evidence is found to conclude that a threshold probability is present in subjects’ minds. Implications for the insurance market are derived.