Coping with Risk: The Role of Insurance, Compensation and Protective Behavior

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Many decisions made by individuals, firms, consumers, citizens' groups, governments, regulatory bodies and courts involve dealing with potential misfortunes or catastrophes before they occur-- through insurance, risk avoidance behavior, or compensation for risk bearing-- or after they occur--through private or government compensation. These decisions often appear to be inconsistant, inequitable or irrational. Insurers, uncertain about future awards, refuse to offer policies against certain risks because they base their decisions on worst-case scenarios. Individuals react to risks inconsistently, treating small risks as though they were nonexistent (failing to wear seatbelts or to take precautions against AIDS) or so large as to overwhelm all other considerations (opposition to genetic recombination). Governmental attempts to respond to such concerns are often ad- hoc, such as the Delaney amendment, resulting in unanticipated contradictory outcomes. This collaborative interdisciplinary research program examines these puzzling features of behavior within a multi-disciplinary tradition of research on biases and fallacies in decision making. It investigates the question of whether these biases distort the functioning of institutions, markets and societal allocation of resources. The research will develop and evaluate several approaches designed to correct decision biases or protect individuals from their effects, including education, novel ways of presenting information, and mixed strategies coupling incentives and regulations with insurance and compensation. The research plan organizes biases into four categories: reference-point effects, in which preferences for outcomes depend on what they are compared to; contingent weighting, in which choice depends on the way in which a decision is expressed; decision rules, in which absolute priority is given to one attribute (e.g. saving money, avoiding catastrophic consequences); and threshold effects, in which small risks or costs (e.g. the risk of one cigarette or the extra cost of low- deductible insurance) are totally ignored even if they are repeated. The research will examine whether such biases affect decisions about offering or purchasing insurance, setting premiums, compensating victims of misfortune, compensating people for the risk of misfortune beforehand, and engaging in protective behavior. Multiple methods will be used, including questionnaires, laboratory studies, experimental markets, process-tracing, field studies, and microeconomic analysis. The results will bear on theoretical controversies within psychology, economics and decision theory about the relevance of biases to real decision making, on the question of whether market competition reduces the effects of bias, and on questions about the nature of bias itself.