PROBABILISTIC INSURANCE

Probabilistic insurance is an insurance policy involving a small proba bility that the consumer will not be reimbursed. Survey data suggest t hat people dislike probabilistic insurance and demand more than a 20% reduction in the premium to compensate for a 1% default risk. While th ese preferences are intuitively appealing they are difficult to reconc ile with expected utility theory. Under highly plausible assumptions a bout the utility function, willingness to pay for probabilistic insura nce should be very close to willingness to pay for standard insurance less the default risk. However, the reluctance to buy probabilistic in surance is predicted by the weighting function of prospect theory. Thi s finding highlights the potential role of the weighting function to e xplain insurance.