On a New Paradigm of Optimal Insurance Demand and Saving in an Intertemporal Framework: Why Is Post-Accident Insurance Demand So High?

Abstract

The real-world insurance markets show that the experience of having an accident increases insurance purchases in the next period relative to insurance purchases when in the immediately prior period there was no accident. There have been several explanations put forward to explain such behaviour, with the leading explanation involving probability updating. In the present paper, using a simple two-period model of intertemporal insurance, we posit a second reason for the effect based upon decreasing absolute risk aversion and consumption smoothing. We argue that under the assumption that the insured has access to a mechanism of savings and loans, then any two consecutive periods of insurance become inter-dependent, whereas without savings they are independent. Our findings show that savings as a consumption smoothing mechanism leads to post-accident insurance being significantly greater than post-no-accident insurance.