MPRAMunich Personal RePEc Archive

Black swan protection: an experimentalinvestigation

Andrea Morone and Ozlem Ozdemir

Univerista degli studi di Bari, Aldo Moro; Dipartimento di StudiAziendali e Giusprivatistici, Bari, Italy, Universitat Jaune I;Departament dEconomia, Castellon, Spain, Middle East TechnicalUniversity; Department of Business Administration, Ankara, Turkey

2012

Online at http://mpra.ub.uni-muenchen.de/38842/MPRA Paper No. 38842, posted 16. May 2012 13:37 UTC

http://mpra.ub.uni-muenchen.de/http://mpra.ub.uni-muenchen.de/38842/

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Black Swan Protection: an Experimental Investigation

Ozlem Ozdemir (Corresponding Author) 1

Middle East Technical University, Department of Business Administration, Ankara, Turkey

Andrea Morone

Universit degli Studi di Bari, Aldo Moro Dipartimento di Studi Aziendali e Giusprivatistici, Bari, Italy

And Universitat Jaune I

Departament d'Economia, Castellon, Spain Abstract

This experimental study investigates insurance decisions in low-probability, high-loss risk

situations. Results indicate that subjects consider the probability of loss (loss size) when they

make buying decisions (paying decisions). Most individuals are risk averse with no specific

threshold probability.

JEL Classification: C91 and D81

Keywords: Black swan, Risk, Insurance, Low probability, High loss, Experiment

1 Professor, Middle East Technical University (METU), Department of Business Administration, 06531 Ankara, Turkey, Phone: +90-312-210 3061, Fax: +90-312-210 7962, Email: yozlem@metu.edu.tr The authors gratefully acknowledge the financial support of the Max Planck Institute of Economics, Jena, Germany.

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1. Introduction

The black swan (i.e. low probability and high loss; LPHL hereafter) events can be expressed as

risky situations where probability of occurrence is low, but the harmful effect can be very

dreadful (e.g., bankruptcy, insolvency, terrorism, and natural disasters). Both individuals and

firms implement different risk reduction mechanisms, such as life insurance, credit insurance,

home insurance, and storm shelters, against these events. However, how people decide to insure

specifically towards LPHL hazards is questionable. Theoretical frameworks concerning

protective measures chosen by individuals against LPHL risk situations have been developed

over the past thirty years (e.g., Arrow, 1996; Cook and Graham, 1975; Dong et al., 1996;

Kunreuther, 1979). Most have consistently demonstrated that insurance markets for high

probability events can be expressed by standard expected utility theory (EUT); however, the

EUT is inadequate to explain decision making processes in low probability risk situations

(Hershey and Schoemaker, 1980). As Morgenstern (1979) mentioned:

[T]he domain of our axioms on utility theory is also restricted.For example, the

probabilities used must be within certain plausible ranges and not go to 0.01 or

even less to 0.001, then be compared to other equally tiny numbers such as 0.02,

etc. (Morgenstern, 1979, p.178).

Most survey studies indicate that some people perceive the risk as if no hazard exists, while

others seem to react to the situation as if it is a frequent risk exposure condition (e.g. Camerer

and Kunreuther, 1989; McClelland et al., 1990; McDaniels et al., 1992; Slovic et al., 1980). The

reasons why individuals behave in two opposite ways have not attracted enough attention in the

literature. One possible reason might be that some people may take into account the low

probability of occurrence and react to LPHL risks as if there is no such risk, while others may

focus on the high loss and thus overreact (Etchart-Vincent, 2004). In fact, Sjberg (1999) finds

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that the demand for risk reduction is influenced by the severity of the hazard and not by the

probability. Yet, some other scholars conclude that people make insurance decisions based on

probability estimates (Slovic et al., 1977)2. The lack of a definite answer to the question of

whether individuals focus on low probability or high loss when they make insurance decisions in

LPHL situations, stresses the necessity for further empirical research.

The present study contributes to this research stream by conducting an experiment to

examine a dominant risk assessing consideration, namely, the probability of loss versus loss

amount on individuals insurance decisions in LPHL risky situations. During the course of this,

we investigate whether using different elicitation methods induces any change in these decisions.

In addition, we check the effects of individuals risk attitudes, their self-determined threshold

probabilities and their demographic characteristics (such as age, income and gender) on these

insurance valuations.

In our experiment, we use two different probabilities of loss (p=0.01 and 0.005)3 and two

loss amounts (all the income and half of the income) to test the dominance of probability and

size of losses on the insurance decision. Furthermore, the design allows us to answer whether the

two different elicitation mechanisms reported in the literature to detect the decision making

process induce similar risk mitigation behaviour. Specifically, we try to examine the differences

in individuals insurance decisions between the case when they are asked to decide whether they

want to buy the insurance or not (asking dichotomous questions to elicit an individuals choice),

and the case when they are asked to state the amount of money they are willing to pay for the

insurance (asking open-ended questions to elicit an individuals valuation). The theoretical

framework does not distinguish risk reduction mechanisms, such as insurance. However, 2 An alternative explanation could be that subjects behave according prospect theory in this case they will overestimate the probability in both cases to about the same larger value. 3 Note that low probability is mostly taken as 0.01 and less in the empirical literature (e.g., Camerer, 1995; McClelland et al., 1993, Ganderton et al., 2000).

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according to the preference reversal phenomenon, individuals may consider different kinds of

information when they make choice versus pricing/valuation decisions (Grether and Plott, 1979;

Holt, 1986; Kagel and Roth, 1995, Segal, 1988; Tversky, Sattah, and Slovic, 1988; Tversky,

Slovic, and Kahneman, 1990). More specifically, when people make choices they focus on the

probability and when they assign values they look at the size of the outcome. Previous

experimental studies about LPHL risks investigate either buying insurance decisions or paying

for insurance decisions. To our knowledge there is no study that investigates both. According to

the most recent experimental study that utilises buying decisions (through asking dichotomous

questions) to examine insurance decisions in LPHL situations, the probability of occurrence of

the risky event plays a dominant role in valuing insurance (Ganderton et al., 2000). However,

another experimental study by McClelland et al. (1993) investigates insurance paying decisions

(using open-ended questions), and concluded that some individuals are willing to pay zero while

others are willing to pay much higher than the expected loss value. This contradiction

necessitates further research.

Moreover, our experimental design also allows us to elicit a threshold probability in

individuals minds and gauge their risk attitudes towards the effects of these insurance decisions.

A threshold probability is presented as the minimum probability in an individuals mind for a

given amount of loss for which he/she buys insurance. Through eliciting individuals threshold

probabilities, we can also test the prospective reference theory, which suggests that people

overestimate the risk if the probability is below a particular threshold probability and

underestimate if it is above the threshold probability (Viscusi and Evans, 1990). We also

determine subjects risk attitudes by following the calculation used by McClelland et al. (1993).

This enables us to test the consistency of our results with the well known fourfold patterns of risk

attitudes (Di Mauro and Maffioletti, 2004). According to the well known fourfold patterns of risk

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attitudes as suggested by Prospect Theory (Kahneman and Tversky, 1979), people are risk averse

for gains and risk seekers for losses in high probability events, and risk averse for losses and risk

seekers for gains in low probability events. Finally, in addition to the effects of threshold

probability and risk attitude, we examine how an individuals endowment in the experiment,

gender, age and income influences his/her insurance buying and paying decisions.

The results of the current study are important for academicians and practitioners in the

insurance market in many aspects. It contributes to the literature by answering whether using

different methods to elicit individuals insurance valuations changes their decisions and affects

the dominant consideration of probability of loss and amount of loss. In other words, the study

answers the question do individuals consider different kinds of information when they mak