A Pedagogical Note on Risk Framing

ABSTRACT This article presents several classroom games that help illustrate the effect of risk framing on choices under uncertainty. These games are presented in the context of Kahneman and Tversky's prospect theory that is an alternative to the traditional expected utility theory. Expected utility theory is a prescriptive model of decision making that explains how people should react to risk, while prospect theory is a descriptive model that explains how people actually do react to risk. These classroom games can be used in introductory risk management courses, insurance courses, and financial risk management courses to help students to understand the effect of context on choices made under uncertainty. Although results from actual classroom experiments are included, these results are not meant to be indicative of normal results but are rather illustrative of the type of results that may arise when alternative framing contexts are used. INTRODUCTION The purpose of this article is to describe a set of classroom games that can be used to illustrate the effects of risk framing on preferences in the presence of risk. Framing refers to how the problem or choice is described. As students become more aware of the effects of framing on preferences, they are better able to fully understand and explain risk management alternatives. Much of the academic literature on optimal choices under risk, and indeed much of the risk management and insurance advice commonly encountered in the nonacademic literature, is based on expected utility theory. Expected utility is a normative, or prescriptive, theory of how individuals should act when faced with uncertain choices. The expected utility theory assumes that individuals are able to accurately quantify various alternatives and make rational decisions based on the value that they assign to each alternative. Rational individuals should act in a manner so as to maximize their utility, with utility being a measure of their desire or preference for one object over another. Individuals are assumed to be able to accurately measure the utility of various alternatives without regard to the manner in which the choices are framed. Individuals are also expected to be consistent in their choices, so that if A is preferred to B and B is preferred to C, then A is also preferred to C. Individuals are assumed to be risk-averse, so that when those choices include some element of risk, the degree of risk aversion can be measured and quantified. The old adage "A bird in the hand is worth two in the bush" is an example of risk aversion. A researcher could use questionnaire data to find the point at which multiple birds in the bush would be the equivalent of a bird in the hand, with the bird in the hand being the nonrisky choice. The degree of risk aversion can then be directly measured. Rather than "birds in the hand versus birds in the bush," researchers typically use money to measure preferences by assigning dollar values to choices, and money is assumed to be an accurate unit of measure for the degree of risk aversion. This is a key concept in risk management and insurance because the degree of risk aversion is assumed to drive the desire for risk transfer through hedging arrangements, insurance, or other means. Nevertheless there is a great deal of existing research that shows that people do not make choices consistent with expected utility. The classroom games discussed in this article revolve around prospect theory, which was developed in the 1970s by Daniel Kahneman and Amos Tversky (hereafter, K-T) as an alternative to expected utility theory. Rather than describing how people should react to given risk situations, prospect theory is a descriptive theory that explains how people actually do choose between risky alternatives. This is an important distinction that is often overlooked in risk management and insurance education. A good risk manager, whether helping to manage the risk of a corporation or helping to manage the risk of an individual or a family, must have a good understanding of risk attitudes in order to effectively implement a risk management program. …