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Economics

Ambiguity aversion and insurance

Profile image of Daniel ClarkeDaniel Clarke

2007

Abstract

This paper considers financial markets for uncertain cashflow streams when participants are averse to model or parameter uncertainty, or more generally averse to ambiguity. Motivated by the desire to better understand why it is difficult to sell rainfall insurance in the developing world, this paper provides theoretical foundations for a type of constraint on private insurance markets intuitively understood by practitioners but not yet satisfactorily incorporated into theory. It is argued that prudential requirements and information asymmetries cause financial institutions to be better modelled as ambiguity averse decision-makers than expected profit maximisers. The model presented also offers explanations for the almost exclusive use of traditional insurance policies which closely match the risk to be insured, and the absence of indexed products as suggested by Shiller (2003). * A dissertation submitted in partial fulfillment of the requirements for the Specialist Applications Dissertation option (SA0) for the qualification of Fellow of the Institute of Actuaries. The word count, including all footnotes and references (but excluding equations) is 12, 170 words. An earlier version of this work, written to be read by academic economists, was submitted as a dissertation for the M.Phil. in Economics at Oxford University. I am indebted to my supervisors James Orr and Stefan Dercon for considerable guidance and encouragement. I am also grateful for helpful discussions with

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