Using Prospect Theory to Explain Annuity and Insurance Market Puzzles
Economic theory suggests that working-age individuals with dependents should purchase enough life insurance to ensure their dependents are financially secure in the event of their untimely death. Economic theory also suggests that retirees should purchase annuities to protect themselves against the risk of outliving their assets, known as longevity risk. Demand for both life insurance and annuities is inconsistent with the predictions of economic theory, however, which presents many puzzles. The author identifies five of these puzzles: (1) few individuals purchase annuities, (2) working-age individuals do not purchase sufficient amounts of life insurance, (3) retirees own too much life insurance, (4) many of those who have purchased annuities also hold life insurance, and (5) most annuity policies have clauses that guarantee a minimum repayment. Gottlieb’s article uses a model of demand for life insurance and annuities, based on prospect theory, to explain each of these five distinct puzzles.
Prospect theory has three key features that help it explain these puzzles. First, the theory defines consumer preferences in terms of gains and losses. An example is people’s different behavior when faced with either gaining or losing $10. Second, consumers are loss averse: they prefer to avoid financial losses rather than to acquire equivalent financial gains. For example, a loss-averse consumer thinks that it is better not to lose $10 than it is to gain $10. Third, consumers are reluctant to risk losing their gains, but accept greater volatility and uncertainty with investments in exchange for a higher expected return to try to recoup losses.