Financial Literacy and Precautionary Insurance

This paper studies an insurance market where individuals have limited financial literacy and perceive insurance policies as opaque in the sense that there is uncertainty about the exact indemnity payment in case of a loss. Third-order risk attitudes play an important role for insurance demand in this context. Showing that sufficiently prudent individuals increase their demand for insurance under contract opacity, this study provides a rationale for precautionary insurance. Insurance companies can then boost insurance demand by increasing the complexity of their contracts; at the same time, contract opacity can provide an incentive for individuals to undertake additional self-protection. As a result, companies have high incentives to offer complex contracts, a situation that provides a strong case for consumer protection.