Thinking and Deciding

INSURANCE AND PROTECTIVE BEHAVIOR 517
loss, the more this argument holds. For losses that are relatively small compared to
lifetime expected wealth, the utility of money is approximately linear, and any small
advantage to insurance is more than compensated by the profit made by the insurance
company, in most cases. This is why you should not buy insurance for small losses,
unless your risk for these losses is much greater than average. Because the insurance
company makes a profit, the expected value of such insurance for average consumers
is negative. Average drivers, then, should buy auto insurance with the highest possible
deductable amount. The same argument applies to maintenance contracts, which
can be seen as a type of insurance against small losses. For the average user of an
appliance, the cost of the contract is greater than the expected benefit.
In fact, most people prefer insurance that pays off more often, both in laboratory
studies and real life (Kunreuther and Slovic, 1978). They often fail to buy insurance
against rare events with very high disutility. Flood insurance in the United States is
subsidized, so that its cost is below its expected value, yet many people who live in
flood plains did not buy it, until they were required to do so in order to get federally
insured mortgages. This requirement can be seen as a prescriptive solution to a
departure from a normative model.
People also fail to take protective action against natural disasters such as earthquakes
and hurricanes. In California, only a minority of homeowners had taken
any protective measures against earthquakes, even after the large Loma Prieta earthquake
of 1989 (Kunreuther, 1999). These measures include such inexpensive — and
clearly cost-effective — steps as strapping water heaters with plumbers’ tape, which
prevents heaters from toppling during an earthquake and thereby causing gas leaks
and fires. The problem is not just that people forget or do not know. In a survey
of hypothetical decisions, most subjects were unwilling to pay the expected value of
protective measures that paid off over several years in reduced risk (such as bolting
one’s house to its foundation), even assuming a 10% discount rate, and even when
the expected savings were explicitly stated in the question ( Kunreuther et al., 1998).
Part of the problem is that people tend to think about low probabilities in one of
two ways. Either they exaggerate the probability, thinking that “it could happen” or
they treat the probability as if it were zero. McClelland, Schulze, and Coursey (1993)
asked laboratory subjects how much they would pay for insurance against losses of
$4 or $40 at various probabilities. At the lowest probability, .01, most subjects were
willing to pay much more than the expected value ($0.04 or $0.40, respectively), but
many subjects (25% for $4, 15% for $40) were willing to pay nothing at all. Few
subjects were in between for low probabilities, although many more subjects offered
approximately the expected value for higher probabilities.
A prescriptive solution for the problem of inadequate protective measures (such
as taping water heaters or buying cars with air bags or other passive restraints) is to
charge reduced insurance premiums for those who take them. Although this method
is used, it is somewhat ineffective because of people’s tendency to integrate the saving
with the cost of the insurance (as described in Chapter 12), so that they see it
as only a small reduction in the disutility of paying the premium. If, however, the
saving is called a “rebate,” consumers seem to find it more attractive (Johnson, Her-