Faculty of Economics and Business Administration Publications Database

An Incentive-Compatible Experiment on Probabilistic Insurance and Implications for an Insurer's Solvency Level

Zimmer, Anja
Schade, Christian
Glenzer, Franca
ISSN-Print: 0022-4367
Link External Source: Online Version
Year: 2016
Keywords: Probabilistic insurance; Default risk; Customer reaction; Solvency level

This article is the first to conduct an incentive-compatible experiment using real monetary payoffs to test the hypothesis of probabilistic insurance, which states that willingness to pay for insurance decreases sharply in the presence of even small default probabilities as compared to a risk-free insurance contract. In our experiment, 181 participants state their willingness to pay for insurance contracts with different levels of default risk. We find that the willingness to pay sharply decreases with increasing default risk. Our results, hence, strongly support the hypothesis of probabilistic insurance. Furthermore, we study the impact of customer reaction to default risk on an insurer's optimal solvency level using our experimentally obtained data on insurance demand. We show that an insurer should choose to be default-free rather than having even a very small default probability. This risk strategy is also optimal when assuming substantial transaction costs for risk management activities undertaken to achieve the maximum solvency level.