Abstract

Often in insurance decision making, there are risk factors on which the insurer has an informational advantage over the consumer. But when the insurer sets and posts a premium for the consumer to consider, the consumer can potentially use the premium as an informational cue for the loss probability, and thereby to reduce the insurer’s informational advantage. We study, by means of a behavioral model, how consumers would use the premium as an informational cue in such contexts. The belief formation process in our model assumes that both prior knowledge and the premium might have an impact on the consumer’s estimate of the loss probability. Moreover, the premium impacts the estimate through an anchoring-and-adjustment process. The model potentially leads to violations of rational expectations, with which the consumer overestimates the loss probability beyond what could be inferred from the premium, given the premise that the insurer must seek to break even or earn an expected profit. Our model analysis moreover implies that the frequency of such violations is non-increasing as the premium increases. Last, the model implies a generally inverted-U relationship between insurance demand and the premium so that the demand is upward sloping at low premium levels and downward sloping at high premium levels. A pilot field study and a laboratory experiment provide robust evidence for our model implications and calibrations for its parameters.