Investigating Microinsurance Issues by Using Laboratory Experiments to Evaluate the Welfare of Insurance

Georgia State University ScholarWorks @ Georgia State University Risk Management and Insurance Dissertations Department of Risk Management and Insurance 5-10-2017 Investigating Microinsurance Issues by Using Laboratory Experiments to Evaluate the Welfare of Insurance Jia Min Ng Follow this and additional works at: https://scholarworks.gsu.edu/rmi_diss Recommended Citation Ng, Jia Min, "Investigating Microinsurance Issues by Using Laboratory Experiments to Evaluate the Welfare of Insurance." Dissertation, Georgia State University, 2017. https://scholarworks.gsu.edu/rmi_diss/41 This Dissertation is brought to you for free and open access by the Department of Risk Management and Insurance at ScholarWorks @ Georgia State University. It has been accepted for inclusion in Risk Management and Insurance Dissertations by an authorized administrator of ScholarWorks @ Georgia State University. For more information, please contact [email protected]. Investigating Microinsurance Issues by Using Laboratory Experiments to Evaluate the Welfare of Insurance by Jia Min Ng A Dissertation Submitted in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in the Robinson College of Business of Georgia State University GEORGIA STATE UNIVERSITY ROBINSON COLLEGE OF BUSINESS 2017 Copyright by Jia Min Ng 2017 ACCEPTANCE This dissertation was prepared under the direction of Jia Min Ng’s Dissertation Committee. It has been approved and accepted by all members of that committee, and it has been accepted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Business Administration in the J. Mack Robinson College of Business of Georgia State University. Richard Phillips, Dean DISSERTATION COMMITTEE Glenn W. Harrison Stephen Shore Alejandro Del Valle Daniel J. Clarke ii ABSTRACT Investigating Microinsurance Issues by Using Laboratory Experiments to Evaluate the Welfare of Insurance by Jia Min Ng April 10, 2017 Committee Chair: Glenn W. Harrison Major Academic Unit: Risk Management and Insurance Over the past decade microinsurance (MI) has grown to be a key risk mitigation tool to help the poor in developing countries step out of poverty. It is now estimated that the global market has grown from 78 million individuals in 2007 to 263 million in 2013, and the potential MI market could be over 3 billion policies, generating over US$30 billion in annual premium revenue (Leach, Ncube and Menon [2014]). However, there are barriers to reaching that potential market size. Many MI projects have been launched to offer the poor the opportunity to further manage their risk, but there are problems that stand in the way of scaling and sustaining these pilot programs that only reach out to small numbers (Smith and Watts [2009]). I contribute to this literature by measuring how insurance impacts an individual’s welfare. Purchasing insurance is a risky choice: there is a certain upfront payment of premium for an uncertain future payout, and hence one’s risk and time preferences need to be taken into account in iii order to evaluate individual welfare of decisions to purchase insurance or not. Welfare of an insurance product depends on an individual’s specific risk preferences. Someone who is more risk averse (loving) may dislike (prefer) the large variance in possible future outcomes more, and value the option of purchasing insurance which would reduce that variance more (less). By using economic theories of risk preferences to quantify the certainty equivalent when insurance is purchased, I explicitly account for the individual’s risk preferences when evaluating the value of the insurance product. Existing literature has used insurance take-up as a proxy for how beneficial insurance is to individuals, assuming that individuals would only purchase insurance if they thought having insurance was better for them than not having insurance. This revealed preference argument only gives us a possible starting point for the welfare evaluation of insurance when we study actual behavior. When an individual’s risk preferences are used to calculate consumer surplus (CS) to measure the expected welfare gain of insurance, however, the welfare effect can be quantified, rather than be limited to a qualitative evaluation when take-up is used. It will also be possible to tell if purchasing (not purchasing) insurance can result in a negative (positive) expected welfare gain, since it is possible for the calculated CS from an actual insurance purchase to be negative. Efficiency is also used as another measure of the expected welfare gain of insurance. It provides a natural normalization of CS for the actual insurance choices made for each individual by comparing it to the maximal expected CS for that individual. I use this methodology of measuring individual welfare to study the impact of a simple indemnity product (Chapter 1), basis risk in index insurance (Chapter 2), and the impact of non-performance risk of the insurer (Chapter 3). The efficiency measure can be used to compare the welfare impact in one chapter against the welfare impact in another chapter, to see if, for instance, the impact of basis risk on welfare is larger than the welfare impact of contract non-performance risk. iv I have chosen to focus on lab environments in my thesis so that I can ensure the maximum “internal validity” on my methodological applications of theory to evaluate welfare. In this sense the lab data can be viewed as “theory with numbers,” but where the numbers refer to real, incentivized behavior. I list two examples of complications in the field. First, due to concerns about time and subject-comprehension level constraints in field experiments, ascertaining subjects’ risk preferences for insurance is typically done through hypothetical surveys or simple tasks where risk preferences cannot be structurally estimated on the individual level. Second, it is difficult to obtain all the data in the field that would allow us to estimate the experimental parameters required to define the insurance contract. These estimates would be needed to set up the decision context the individual faces in a field experiment. In comparison, my approach provides a way to structurally identify the behavioral basis of sub-optimal insurance decisions. My hope is to see insights from this type of lab environment used to guide field applications. Chapter 1 illustrates the application of economic theory to the welfare evaluation of insurance policies in a controlled laboratory experiment. Economic theory is used to evaluate the expected welfare gain from insurance products on offer to individuals. If the risk preferences of the individual, and subjective beliefs about loss contingencies and likelihood of payout are known, there is a certainty equivalent of the risky insurance policy that can be compared to the certain insurance premium. This simple logic extends to non-standard models of risk preferences, such as those in which individuals exhibit “optimism” or “pessimism” about loss contingencies in their evaluation of the risky insurance policy. This chapter describes the methodology of estimating the risk preferences of individuals from one task, and separately presenting the individual with a number of simple indemnity insurance policies in which loss contingencies are objective. Hence subjective beliefs about loss contingencies do not need to be considered. The expected consumer surplus gained or foregone from observed v take-up decisions is then estimated. The efficiency of decisions made by each individual is also estimated. There is striking evidence of foregone expected consumer surplus and efficiency from incorrect take-up decisions. Take-up, which is commonly used as a metric for welfare evaluations of insurance products, is shown to not be a good indicator of the expected welfare gain from insurance. Chapter 2 extends the methodology from Chapter 1 to estimate the welfare of index insurance. An index insurance product will only fully compensate for a loss based on a predetermined and objective index, and not whether the individual experiences a loss. Index insurance was conceived to be a product that would simplify the claim settlement process and make it more objective, reducing transaction costs and moral hazard. However, index insurance also exposes the insured to basis risk, which arises because there can be a mismatch between the index measurement and the actual losses of the insured. It is not easy to predict the direction in which basis risk is going to affect insurance demand even, even under Expected Utility Theory, in contrast to the clear and strong predictions for standard indemnity insurance products. Index insurance can be theoretically conceptualized as a situation in which the individual faces compound risk, where one layer of risk corresponds to the potential individual’s loss and the other layer of risk is created by the potential mismatch between the index measurement and the actual loss. Experimental evidence shows that people exhibit preferences for compound risks that are different from preferences exhibited for their actuarially-equivalent counterparts. This chapter studies the potential link between index insurance demand and attitudes towards compound risks. It tests the hypothesis that the compound risk nature of index insurance induced by basis risk negatively affects both the demand for the product and the welfare of individuals making take-up decisions. The impact of basis risk on insurance take-up and on expected welfare is studied

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