Risk aversion, reference points, loss dimensions and insurance purchasing behavior

This paper examines the impact of the perceived reference point of a decision maker with respect to a potential loss situation, and the impact of the loss dimensions of that loss situation, on the desire for insurance by the decision maker. Attempts have been made to guide behavior with normative theories and also to describe actual behavior with positive theories. Utility theory has been used in both instances and is perhaps the most widely accepted theory of decision making. Utility theory is not without its critics though, and because of the observed deviations of actual behavior from what utility theory prescribes or predicts, other theories have been suggested as alternatives. Prospect theory is one of those alternatives and is perhaps the most widely known alternative to utility theory.;Even though prospect theory is offered as an alternative to utility theory, it is not clear that observed behavior coincides with prospect theory. For example, several studies have shown people prefer insurance against low severity/high probability events which is inconsistent with the weighting function of prospect theory.;This study differs from earlier studies in several ways which serve to make the decision situation in which the experiment was run in a classroom setting. Four loss situations were presented one at a time for which the subjects were to indicate how much they were willing to pay for insurance against the potential losses. One situation was selected, the "required premium" was determined and then it was actually simulated to determine the subjects final wealth position.;Results showed probability was the dimension on which subjects focused their attention when evaluating the purchase of insurance, and the methods used to determine their desire for insurance were unsophisticated. Severity did not have a significant influence on behavior which may indicate consumer understanding of risk management concepts needs to be improved.