A Gentle Introduction to Risk Aversion and Utility Theory

ABSTRACT While the topics of risk aversion and utility theory have been discussed extensively in the academic literature on risk and insurance, this literature does not include a pedagogical discussion that is widely accessible for classroom use. This article provides a practical introduction to risk aversion that is designed for readers with little prerequisite course work in economics or statistics. We describe a simple model of insurance demand that can be applied to the property, liability, life, and health insurance markets. We also demonstrate how risk aversion affects a variety of real-life insurance decisions made under conditions of uncertainty, including how much the market will bear to pay for insurance administrative expenses and how demand varies for different types of auto insurance coverage. Exercises and practice problems are provided so that readers can test their mastery of the concepts presented in the article. An instructional note on using this article to teach risk aversion in the classroom is also provided. INTRODUCTION One of the largest and least understood industries in the world is the insurance industry. Browne et al. (2000) estimate that 8 percent of the world's GDP is spent on insurance products. Global insurance premiums totaled $3.7 trillion in 2006, and the United States ranked first among all countries as the largest consumer of insurance products in the world (Swiss Re, 2007). For most noncommercial consumers in the United States, insurance consumption has focused on personal insurance products, such as auto, health, homeowners, life, and retirement insurance products. But while they spend a great deal of money on insurance, many consumers appear to have a limited understanding of the factors that affect their demand for insurance products.1 People buy insurance for a variety of reasons. In some instances, the purchase is required by law, as is the case for compulsory auto liability insurance. In other cases, consumers buy insurance to satisfy the requirements of other parties that they are doing business with; e.g., mortgage lenders require that homeowners buy insurance on the homes that the lenders are financing as a condition of obtaining loans. Many others buy insurance due to a more abstract reason, a behavioral tendency known as risk aversion. As it relates to the demand for insurance, risk aversion refers to the tendency to prefer to pay a defined sum of money that is known with certainty instead of being exposed to the risk of suffering a larger and uncertain financial loss in the future. Thus, the practice of individuals buying insurance protection instead of bearing risk without insurance reflects risk aversion. Scholarly texts typically explain the concept of risk aversion using an economic model called utility theory. Readers with previous course work in economics can find excellent discussions on utility theory, risk aversion, and the demand for insurance in several different books.2 Readers without such course work may find it difficult to understand utility theory, however, as discussions on the topic are usually written assuming that readers have a fairly advanced understanding of economics. Moreover, unless they are particularly familiar with the insurance industry, readers often find it difficult to relate the concepts discussed in most descriptions of utility theory to practical applications in their insurance consumption decisions. The objective of this article is to provide a general introduction to utility theory and risk aversion as it applies to the demand for insurance. This primer thus provides an intermediate reading that covers the prerequisites assumed in more advanced discussions on the topic. To demonstrate that utility theory is not an abstract "ivory tower" exercise with limited relevance to the real world, the article includes several examples that show how risk aversion relates to real-life insurance demand patterns. …