RICHARD WATT, FRANCISCO J.

VZQUEZ and IGNACIO MORENO

AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS
ABSTRACT. We describe the results of an experiment on decision making in an
insurance context. The experiment was designed to test for the underlying ration-
ality of insurance consumers, where rationality is understood in usual economic
terms. In particular, using expected utility as the preference function, we test for
positive marginal utility, risk aversion, and decreasing absolute risk aversion, all
of which are normal postulates for any microeconomic decision context under
uncertainty or risk. We nd that there the discrepancy fromrational decision mak-
ing increases with the sophistication of the rationality criteria, that irrationality
concerning fair premium contracts is uncharacteristically high, and that the slope
of absolute risk aversion seems to depend on the format of the insurance contract.
KEY WORDS: Contract format, Experiments, Insurance, Premiums, Rationality
1. INTRODUCTION
In order to arrive at useful conclusions, a general aspect of almost
all microeconomic models is the underlying assumption of indi-
vidual rationality. Certainly, the microeconomics of insurance is no
exception. This becomes particularly important when the optimal
design of insurance contracts is considered since, in order to cor-
rectly address the preferences of insurance consumers, it is neces-
sary to rstly assume that they are, in some sense, rational. Model-
ling rationality normally implies the assumption of a given objective
function (utility function), dened within a particular class of func-
tions. For example, dening the utility function over wealth, and
assuming that rationality implies (among other things) that more
wealth is preferred to less, then the utility function must be within
the class of strictly increasing functions.
In this paper, we describe an experiment that was carried out
with the objective of testing the underlying rationality of economic
agents, within the context of choices among insurance contracts. We
dene three basic orders of rationality, with higher orders imply-
ing greater sophistication as to the signs of the derivatives of the
Theory and Decision 51: 247296, 2001.
2002 Kluwer Academic Publishers. Printed in the Netherlands.
248 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

underlying preference function, assuming that such a function ex-
ists. We test for fullment of each order of rationality using well
known results in insurance economics. It is hoped that the results
of the experiment can be useful for the general objective of optimal
insurance contract design and marketing.
The paper is structured as follows; in the next section we out-
line the generally accepted description of rationality, and using this
description, we dene the three orders of rationality that the exper-
iment tests. In section three, the design and structure of the experi-
ment is given and this is followed in section four with an indication
of how the experiment tests rationality. Section ve presents the
results of the experiment, and section six concludes.
2. RATIONALITY IN CHOICE UNDER RISK
The experiment that is discussed in this paper tests three different
orders of rationality in insurance decisions. First and second order
rationality differ only with respect to the sign of the second order
derivative of the underlying utility function, while third order ra-
tionality also tests for the slope of absolute risk aversion. In order
to test for rationality at all, we must establish rstly what we un-
derstand by rational decisions, and then consider possible deviations
from such behaviour within the answers that the subjects give on the
experiment. Here, we take rationality as being decision making that
is consistent with a utility function that is dened within a particu-
lar class (correspondingly, irrationality is dened as being decision
making that is inconsistent with such a utility function), and so we
must rstly make clear at least two underlying assumptions.
Assumption 1. Individuals preferences for wealth can be repres-
ented by a utility function of the type u(x), that is continuous and
that admits, at least, its rst three derivatives. It is assumed that all
derivatives of u(x) are monotone (that is, they do not change sign).
Assumption 2. Individuals preferences satisfy the conditions that
are sufcient for expected utility to be the relevant representation
of preferences over lotteries (see Von Neumann and Morgenstern,
1947).
These two assumptions are very common throughout the literat-
ure, with the weakest being assumption 2. However, even assump-
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 249
tion 2 is not required for at least one of the tests that we consider
in the experiment, namely the preference for the deductible con-
tract format over all others. In any case, assumption 2 is only used
here for simplicity, and most (if not all) of the tests performed here
would also be valid under rst and second order stochastic domin-
ance, thereby admitting a much wider variety of preference under
uncertainty functions.
First order rationality. We dene rst order rationality as de-
cision making that is consistent with a utility function that displays
positive marginal utility for all wealth levels, u

(x) > 0 for all x.

First order rationality is the weakest possible description of ra-
tionality, implying simply that more wealth is preferred to less. It is
important to note that, under rst order rationality, no assumptions at
all are made concerning the signs of the second or third derivatives
of the utility function.
Second order rationality. Assuming that marginal utility is pos-
itive and that a subject has, through particular choices, revealed that
his utility function displays risk aversion (second derivative negat-
ive, u

(x) < 0 for all x), then second order rationality is dened as
decision making that is consistent with a negative second derivative
of the utility function.
It is important to note that second order rationality is not an
assumption of risk aversion, in the same way that rst order ra-
tionality is an assumption of positive marginal utility. Second order
rationality is only tested once a subject has revealed that her utility
function is concave. Hence, in the experiment, there are a series of
questions that are designed to reveal risk aversion, and only once
the answers to these questions are taken into account do we test for
choices consistent with risk aversion.
One of the most important aspects of the experiment is that, once
rst order rationality and risk aversion have been established, we
can then test for the preference of deductible contracts (see Arrow,
1963, 1971). This test is important for two reasons; rstly, as was
shown by Gollier and Schlesinger (1996), it does not require the
assumption of expected utility. Secondly, as far as we are aware,
this is the only experiment that specically tests this famous result.
Third order rationality. We dene third order rationality as con-
sistency in decision making with respect to the sign of the derivative
250 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

of absolute risk aversion (as dened by the ArrowPratt measure of
absolute risk aversion). That is, we offer subjects two opportunities
to, implicitly, declare the slope of their absolute risk aversion func-
tion, and we dene irrationality as being contradictory decisions on
each of these questions.
Although we are able to test for the slope of absolute risk aver-
sion, whenever this is decreasing (the most commonly expected res-
ult) we cannot test for decisions that are then consistent with this
information, since as is well known, in this case the relevant substi-
tution and income effects have opposing sign.
Finally, we note in passing that, although our stated objective is to
study irrationality, it is naturally impossible to separate irrationality
from simply misunderstanding. That is, when a decision is repor-
ted that is inconsistent with a rationality hypothesis, we can never
be certain whether the inconsistency is due to the subject suffering
some form of irrationality, or simply having misunderstood the situ-
ation, the true implications of the insurance contracts on offer, or
indeed, making an error in her decision. In general, we shall refer
to inconsistencies as irrationalities, without attempting to decide
the underlying reason for the inconsistency, although in some cases
(above all, in rst order rationality) the rationality requirement is so
obvious that it does seem more likely that the inconsistency is due
to a misunderstanding or a simple mistake.
3. DESCRIPTION OF THE EXPERIMENT
3.1. The insurable risks
Participants were shown 10 independent risk situations, with two
possible insurance options for each. Each risk situation had only two
possible outcomes; a large loss, L
1
, and a small loss, L
2
, such that
L
1
> L
2
0. The two possible insurance schemes were, on the one
hand, a series of contracts with deductibles, and on the other, con-
tracts with an upper limit on the risk that the individuals possible
loss. Both insurance schemes were presented with discrete incre-
ments in coverage, between full coverage and no coverage at all,
with the corresponding premium clearly indicated. In all cases, the
premiums were proportional to the expected value of the indemnity,
and in two of the ten situations, the premiums were fair. Subjects
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 251
TABLE I
The 10 risk situations.
Situation L
1
L
2
p
1 140 000 0 0.8 1
2 140 000 20 000 0.8 1
3 70 000 0 0.7 1.1
4 70 000 0 0.9 1.1
5 70 000 10,000 0.7 1.1
6 140 000 10 000 0.7 1.1
7 140 000 10 000 0.8 1.1
8 140 000 20 000 0.8 1.1
9 140 000 20 000 0.7 1.1
10 140 000 20 000 0.9 1.1
were asked to indicate their preferred contract from each of the two
insurance schemes, and then to indicate which of the two preferred
contracts was their overall preferred choice. The documents that
were given to the subjects are included here as Appendix 1.
The 10 risk situations are set out in Table I, where p is the prob-
ability of the outcome L
2
, and is the loading factor used for the
premiums ( = 1 indicates an actuarially fair premium, and > 1
indicates an unfair, or loaded, premium). All the possible losses, and
premiums, are expressed in pesetas (10 000 pesetas is approximately
US$54).
Two different situations are related when they differ with re-
spect to only one of the four variables that dene them. Choices
between any two related situations will reveal information regarding
the preferences of the subject, above all, on the rationality of the
subject concerned.
The 10 risk situations are related in the following way; rstly, the
rst two situations have actuarially fair premiums, while the other
eight are loaded (actuarially unfair). The 10 situations are grouped
in blocks of two related situations, but situations 2 and 8 are also
related (difference in loading factor), as are situations 7 and 8, situ-
ations 3 and 5, and situations 6 and 9 (difference in small loss),
252 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

situations 6 and 7 (difference in probability), and situations 8, 9 and
10 (difference in probability).
Participants were shown the risk situations in exactly the same
order as in Table I, with the intention that they do notice the relation-
ships between each group of two situations, but not the relationships
extending beyond the two clustered situations.
3.2. Insurance contracts
For each of the 10 risk situations, participants were offered two
tables of insurance options or contracts. The rst table had de-
ductible contracts, and the second had contracts with an upper limit
on the risk faced by the individual. In both cases, the increments
in coverage were expressed in steps of 10 000 pesetas (US$54 ap-
proximately), in order to reduce the number of options that each
participant had to consider to a reasonable size. This discrete aspect
of the experiment has certain, possibly important, effects on the
results, which will be discussed below.
For each level of coverage (and for each type of contract), the
corresponding premium was also clearly stated (also expressed in
pesetas). Except for the rst two situations, the premiums all had a
loading factor that was strictly greater than 1. Concretely, denoting
a premium by , and the expected value of indemnity payments by
EV, the premiums are calculated as follows:
(i) deductible contracts (deductible is d)
VE(d) = kp(L
2
d) +(1p)(L
1
d); k = 1 if d < L
2
; k =
0 if d L
2
(d) = VE(d).
(ii) upper limit contracts (coverage limit is c)
VE(c) = (1 k)[pL
2
+(1 p)c] + kc; k = 1 if c < L
2
; k =
0 if c L
2
(c) = VE(c).
3.3. Participants and incentives
The subjects that participated in the experiment were all undergradu-
ate students of economics at the Universidad Autnoma de Madrid.
Two groups of students participated in the experiment. Both groups
had been taught introductory microeconomic theory (including un-
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 253
certainty), but had not seen (in class) any material directly related to
optimal insurance decisions. In order that the participants had a dir-
ect incentive to answer the experiment seriously, it was announced
that the participant whose answers displayed the most consistency
and rationality would win a monetary prize of 200 000 pesetas
(approximately US$1100). The rst group of students answered the
experiment in class time (about an hour), while the second group
took the experiment home and handed their answers in the next day.
Of those that took the questionaire home, a considerable number
of participants did not hand in their answers, hence the rst group
outnumbered the second, although more participants were initially
given the questionaire in the second group than in the rst.
Aside from the usual considerations for using students as ex-
perimental subjects (low cost, availability, etc.), it was hoped that
students would understand the questions in the experiment fully,
above all, the notion of probability. We found that certain other indi-
viduals, while real-life insurance consumers, did not properly under-
stand the notion of probability. In any case, in the instructions that
accompanied the experiment, the notion of probability was clearly
explained (in each risk situation, the probabilities were expressed
in percentage terms, which we found enhanced the understanding
of the situation), as were the implications of each type of contract
(see Appendix 1). Furthermore, Schoemaker and Kunreuther (1979)
nd that students and real insurance clients do not differ substan-
tially in insurance decisions, hence our subjects are likely to be
representative of a far wider group of insurance consumers.
4. SOME THEORETICALLY EXPECTED RESULTS
If we base our expectations of rational behaviour on the expec-
ted utility hypothesis, then several results that are consistent with
correct optimising can be directly tested using the results of the
experiment questionnaires. To do so, we only assume that the ex-
periment subject has a utility function for money of u(x), which is
assumed to be strictly increasing at all wealth levels, u

(x) > 0,
that the second derivative of utility has a constant sign, and that the
individual possesses some strictly positive amount of wealth, w, that
is independent of the wealth at risk. The expected results that are
254 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

given here are all well known from the existing insurance literature,
although in the interests of completeness, their formal proofs are
collected in Appendix 2. Throughout, the reader is reminded that the
optimal decision when a deductible contract format is considered
is denoted by d

, while the optimal decision when an upper limit

contract format is considered is denoted by c

.
4.1. First order rationality
Result 1: Assuming , the optimal deductible will always satisfy
d

> L
2
.
Result 2: No interior solution with 0 < c L
2
exists if > 1.
Results 1 and 2 only depend upon marginal utility being positive,
hence they hold for all risk averse, risk neutral and risk loving indi-
viduals who prefer more wealth to less. Hence, rst order rationality
is violated by subjects who choose either a deductible that is less
than the small loss, or strictly positive coverage that is less than the
small loss. There are six situations in the experiment that can be
used to test for rst order rationality (situations 510), since these
are the situations that have a loading factor strictly greater than one,
and for which the small loss is strictly positive.
It is also worthwhile to point out there that, while the theoretical
optimal deductible cannot be equal to the small loss, due to the dis-
crete nature of the choices given to subjects, we cannot conclude that
d

= L
2
constitutes a violation of rst order rationality. A subject
may have a theoretical optimum strictly greater than, although close
to, the small loss, and chooses the small loss on the experiment be-
cause it is the deductible that is closest to his theoretical optimum.
For this reason, we dene rst order irrationality with respect to
deductible contracts to be d

< L
2
. On the other hand, note that
there is no need to exclude limit insurance purchases in upper limit
contracts (c

= L
2
) from being irrational, since such a purchase is
always strictly dominated by c

= 0.
4.2. Second order rationality
Result 3. If > 1, and if the optimal deductible is less than the
large loss value, that is, d

< L
1
, then the individual must be risk
averse, i.e. u

(x) < 0.
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 255
Result 4. If > 1, and the optimal coverage satises c

> L
2
,
then the subject is risk averse, i.e. u

(x) < 0.
Results 3 and 4 are tested with situations 310, for which > 1.
Once again, we note that, due to the discrete nature of the choice set,
subjects that choose exactly d

= L
1
or c

= L
2
may still be risk
averse. Furthermore, we cannot conclude that a subject that chooses
some deductibles strictly less than the large loss and others equal to
this limit, and/or some upper limit coverage amounts that are strictly
greater than the small loss and others at this limit, violates in any
way second order rationality.
Result 5. If the individual is risk averse, and if = 1, then the
optimal solution is to set the deductible equal to the small loss, that
is, full coverage is purchased.
Result 6. If the individual is risk averse, and if = 1, then the
optimal coverage must be set equal to the large loss, c

= L
1
.
Results 5 and 6 are a rst test of second order rationality. If an
individual has revealed himself to be risk averse (results 3 and 4),
then on questions 1 and 2 of the experiment, he should have chosen
full coverage.
Result 7. If the individual is risk averse and if > 1, then an
increase in the small loss, L
2
, will increase the optimal deductible,
d

/L
2
> 0.
Result 8. If the individual is risk averse and if > 1, an increase
in the large loss will increase the amount of coverage in an interior
solution, c

/L
1
> 0.
Results 7 and 8 are a second test of second order rationality. In
the experiment, the effect of an increase in the small loss, ceterus
paribus, is tested with situations 7 and 8, situations 3 and 5, and
situations 6 and 9. Result 5 indicates that all individuals that selected
an internal deductible on situations 310 have a higher theoretical
optimal deductible on situation 8 than on situation 7, a higher the-
oretical deductible on situation 5 than 3, and a higher theoretical
optimal deductible on situation 9 than on situation 6. Once again,
the discrete nature of the coverage choices limits us to consider
irrationality of second order, that is subjects who, having declared
themselves to be risk averse, then choose a smaller deductible on
situation 8 than on 7, a smaller deductible on situation 5 than on 3,
and a smaller deductible on situation 9 than on 6.
256 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

Similarly, the effect of an increase in the large loss is tested with
situations 5 and 6. Result 8 indicates that all subjects who have
revealed themselves to be risk averse should then select a higher
optimal coverage on situation 6 than on situation 5, although our
test is for irrationality (lower coverage on situation 6 than on 5).
Result 9. The optimal deductible contract is preferred to the op-
timal upper limit contract.
Proof. See Gollier and Schlessinger (1996).
Result 9 is a nal test of second order rationality, since Arrows
theoremof the optimality of the deductible format implies that, when
asked to indicate the preference between the chosen optimal de-
ductible contract and the optimal upper limit coverage contract, risk
averse individuals should select the former. As always, we cannot
expect the frequency of preference for the optimal deductible con-
tract to be absolute, since it may turn out that the theoretically op-
timal deductible contract is not among those offered, and the best
upper limit contract of those offered may be preferred to the best
deductible contract of those offered. However, we do expect that
at least the frequency of preference for the deductible format to
be greater than that of the upper limit coverage format. As is well
known, although Arrow (1971) proves result 9 for the case of expec-
ted utility, the result is robust to other types of preference functional.
In particular, Gollier and Schlesinger (1996) show that it holds for
any preference functional that satises second order stochastic dom-
inance.
4.3. Third order rationality
Result 10. If the individual is risk averse, and if > 1, then if an
increase in the large loss L
1
has the effect of decreasing (increas-
ing) the optimal deductible for a risk averse subject, then the utility
function satises decreasing (increasing) absolute risk aversion.
Result 11. If the individual is risk averse, and if > 1, then if an
increase in the small loss has the effect of increasing (decreasing)
the optimal coverage, then the utility function displays decreasing
(increasing) absolute risk aversion.
The only rationality test that we can perform with respect to third
order rationality is that the subject does not declare a different slope
of absolute risk aversion under result 10 as under result 11. Result
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 257
TABLE II
Summary of experimental results.
Situation 1 2 3 4 5 6 7 8 9 10
Average c 5.87 6.01 3.30 2.25 3.10 6.29 5.72 5.44 6.11 5.10
Average d 7.51 6.28 3.47 4.52 3.38 6.62 7.05 6.50 6.67 6.16
Freq. d < L1 0.96 0.98 0.98 0.80 0.99 0.98 0.97 0.97 0.98 0.98
Freq. c > L2 0.97 0.84 0.98 0.81 0.83 0.90 0.88 0.81 0.87 0.69
10 is tested with the answers given to situations 5 and 6, while result
11 is tested three times with the answers given to situations 7 and
8, the answers given to situations 6 and 9, and the answers given to
situations 3 and 5.
5. EXPERIMENTAL RESULTS
In this section we describe the results of the experiment, beginning
with rst order rationality, followed by second order rationality and
nally we describe third order rationality. Most of the results are
presented in tables. Here in the main text we summarise all not-
able aspects of the data. In the interests of simplicity, here we shall
refer to the deductible contracts as d-contracts, and the upper limit
coverage contracts as c-contracts.
Before going on to discuss each of the orders of rationality in
turn, we summarise the results of the experiment in Table II (shows
the average choice of contract over both of the two groups of stu-
dents, together with the frequency with which respondents indicated
risk aversion, i.e. a deductible strictly less than the large loss, and an
upper limit coverage that is strictly greater than the small loss). The
information in Table II is also shown graphically in Figures 13.
5.1. First order rationality
First order rationality is tested with the choices of optimal insurance
contracts on questions 5 to 10. Recall that, from results 1 and 2, a
choice of a deductible that is strictly smaller than the small loss, or a
choice of an upper limit coverage that is greater than 0 but less than
258 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

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AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 259
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1
3
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1
0
7
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2
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1
3
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1
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2
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4
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8
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2
2
0
4
1
0
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8
8
0
0
0
1
2
1
0
260 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

T
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d
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1
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8
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1
1
1
2
2
4
5
7
0
0
6
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1
N
A
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2
2
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7
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7
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0
1
1
1
1
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 261
T
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9
0
0
.
2
3
262 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

Figure 1. Average insurance purchase, d-contracts.
Figure 2. Average insurance purchase, c-contracts.
or equal to the small loss is indicative of negative marginal utility,
that is, a negatively sloped utility function. In Tables IIIA and IIIB
(the results of groups 1 and 2, respectively), we report the results of
the test of rst order rationality in columns 1 and 2. The tables report
the number of times that a respondent answered irrationally, that is,
the number of times the respondent violates rst order rationality
(the maximum is six for each of the two contract types, since rst
order rationality is tested with situations 510).
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 263
T
A
B
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F
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A
2
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9
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8
8
0
0
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0
2
2
4
2
0
0
0
6
7
0
0
1
0
2
2
2
264 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

T
A
B
L
E
I
I
I
B
C
o
n
t
i
n
u
e
d
.
0
<
c
=
<
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2
d
<
L
2
c
>
L
2
0
<
=
d
<
L
1
c
6
<
c
5
d
8
<
d
7
d
3
>
d
5
d
6
>
d
9
c
<
L
1
d
>
L
2
c

d
2
1
6
0
1
7
0
1
0
1
2
2
0
2
2
0
3
8
8
0
0
0
0
0
1
2
2
3
0
0
8
8
0
0
0
0
2
2
3
2
4
0
0
8
8
0
0
0
0
2
2
7
2
5
0
0
8
8
0
0
0
1
1
2
3
2
6
6
0
0
6
0
1
1
1
2
2
2
2
7
1
0
7
8
0
1
1
1
2
1
5
2
8
1
0
7
8
0
0
0
0
2
2
7
2
9
0
1
7
8
0
0
1
0
2
1
5
3
0
0
0
8
8
0
1
0
0
2
2
5
3
1
3
0
5
8
0
1
1
1
2
2
7
3
2
0
0
8
8
0
0
0
1
2
2
8
3
3
2
0
5
8
0
1
0
0
2
1
3
3
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1
1
7
8
0
1
1
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2
2
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2
2
5
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6
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0
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1
1
1
2
2
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1
6
8
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0
1
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2
2
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3
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2
1
6
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1
0
2
2
5
3
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2
1
6
8
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0
1
0
2
2
0
4
0
0
0
8
8
0
1
0
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2
2
1
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 265
T
A
B
L
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I
I
I
B
F
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r
s
t
a
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d
s
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c
o
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L
1
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6
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5
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8
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3
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5
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6
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9
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d
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1
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0
8
8
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1
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2
2
2
4
2
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8
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1
3
4
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1
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7
8
0
1
1
1
2
2
4
4
4
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0
8
8
0
0
0
1
2
2
4
4
5
1
0
5
6
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0
0
0
2
1
3
4
6
4
5
3
8
0
0
0
0
2
0
4
4
7
0
4
8
8
0
0
0
1
2
1
8
4
8
0
4
8
8
0
0
0
1
2
1
8
4
9
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8
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8
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2
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1
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2
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2
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1
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7
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4
0
266 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

Figure 3. Frequency of risk averse responses.
In group 1, of 77 total respondents, 45 (58.44%) show no sign at
all of rst order rationality, that is, 32 respondents (41.56%) show
some degree of rst order rationality. However, noting that there
is a maximum of six questions on which a given respondent may
indicate rst order irrationality, with two options on each question
(i.e., a total of 12 possible irrational answers) there are only three
respondents who have four or more irrational answers. In fact, the
total number of irrational answers on d-contract questions over the
77 respondents was 39, and on c-contract questions there were 21
irrational answers. This gives a frequency of irrationality of 0.08
in d-contracts and 0.05 in c-contracts for this group (a frequency
of 1 would indicate irrationality at every possibility, while 0 would
indicate no irrationality at all).
In group 2, reported in Table IIIB, 28 of the 57 respondents
(49.12%) have no rst order irrational answers, leaving 29 respond-
ents (50.88%) with some degree of rst order irrationality. This
measure indicates that in group 2 there is a somewhat grater propor-
tion of respondents that show some degree of rst order irrationality
than in group 1, although given the small sizes of the two groups,
this difference is not important. In group 2, 6 respondents gave at
least 4 answers that violate rst order rationality. Over all, group 2
has a frequency of rst order irrationality on d-contracts of 0.12 and
of 0.10 on c-contracts, about double the frequency of group 1. The
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 267
fact that group 2 shows more rst order irrationality than group 1
is surprising, since group 2 is the group that took the questionaire
home for an evening (they had 24 hours to study the questions and
to consider their answers) while group 1 answered the questions in
about an hour in class time.
We conclude that rst order irrationality is not rampant, but is
more frequent than what one might expect. The overall frequency
of rst order rationality is low (generally below 0,1) although the
proportion of respondents that answered at least one situation incon-
sistently with rst order rationality is high (between 40 and 50%).
Given that almost all respondents who indicate some degree of rst
order irrationality do so in a limited fashion (that is, on only one or
two of 12 possible answers), it would seem that they simply were
mistaken on these questions. Other respondents seem to have mis-
understood one of the two contract formats entirely. For example, in
group 2, respondent 1 is highly rst order irrational on c-contracts
but not at all on d-contracts, while respondents 21 and 26 were
both highly rst order irrational on d-contracts but not at all on c-
contracts. This suggests that one of the two contract formats was not
properly understood.
5.2. Second order rationality
The results of second order rationality are also shown in Tables IIIA
and IIIB. Columns 3 and 4 of these two tables count how many of
the answers are indicative of risk aversion (under results 3 and 4), for
d-contracts and for c-contracts, respectively. The numbers reported
are the number of times a respondent selected a deductible that is
strictly less than the large loss, or an upper coverage that is strictly
greater than the small loss. Note that there are some responses on d-
contracts that satisfy risk aversion (are less than the large loss) and
that are rst order irrational (they are also less than the small loss).
We have tentatively decided to keep these responses in the data set,
since it is a manifest statement of risk aversion, indeed so strong that
the respondent has fallen into the rst order irrationality trap.
Over all respondents show a very high degree of risk aversion.
Risk aversion can be measured on questions 310, hence for each
contract type there are eight possible manifestations of risk aversion.
In group 1, the average number in column 3 is 6.77 and the average
268 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

number in column 4 is 7.75. These averages can be expressed as the
frequency with which any given respondent displays risk aversion
on any given question is 0.85 for c-contracts (6.77 8) and 0.97
for d-contracts (7.75 8). The same averages for group 2 are 6.56
(average number of times that respondents show risk aversion on
c-contracts) and 7.42 (average number of times that respondents
show risk aversion on d-contracts). The corresponding frequencies
are 0.82 and 0.93, respectively, slightly less than the same numbers
for group 1, but clearly still very high. Over the two groups, only two
respondents (both in group 2) show risk aversion on at most four of
the 16 possibilities. We conclude that, over all, our subjects are risk
averse (indeed, only one respondent respondent 2 in group 2 can-
not be considered to be risk averse. The answers that this respondent
gave on all second order rationality tests have been excluded).
Given that our subjects are, in general, risk averse, we can go
ahead and consider second order rationality. We begin with results
7 and 8, that is, how an increase in the small loss affects the optimal
deductible (risk averse subjects should increase the optimal deduct-
ible), and how an increase in the large loss affects the optimal upper
limit coverage (risk averse subjects should increase their coverage).
These effects are tested by the answers to questions 7 and 8, 3 and 5
and 6 and 9 (increase in small loss) and questions 5 and 6 (increase
in large loss). As before, we can only test for second order irra-
tionality, that is, individuals who decrease their optimal deductible
when the small loss increases, and individuals who decrease their
optimal upper limit coverage when the large loss increases, since the
discrete nature of the choices implies that no rationality inferences
can be drawn from an individual does not alter his answers. The
relevant results are presented in columns 5 to 10 of each of Tables
IIIA and IIIB. In particular, column 5 in each table shows 1 if the
subject answered irrationally to the c-contract question (result 8),
and columns 6, 7 and 8 show 1 if the subject answered irrationally
to the d-contract questions (result 7).
In group 1, only four subjects out of 77 (5.19%) answered ir-
rationally to the c-contract second order rationality question. How-
ever, in the same group, irrationality on the relevant d-contract ques-
tions was far greater; 42 respondents (54.54%) answered irrationally
over questions 7 and 8, and 28 (36.36%) answered irrationally on
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 269
each of the question groups 3 and 5, and 6 and 9. There is no not-
able correspondence between the four subjects that answered the
c-contract second order rationality question irrationally and their
relative d-contract second order irrationality. There are also very
few respondents (concretely there are only three, or 3.89% of all
respondents) who display second order irrationality on all three d-
contract questions.
Carrying out the same analysis of the responses of group 2, we
note that there are no signicant differences. Once again, there is
a far greater incidence of second order irrationality on d-contract
questions (respectively, 30.36, 37.5 and 28.57% of respondents dis-
played second order irrationality on the three d-contract question
groups) than on the c-contract questions (a second order irrationality
incidence of only 3.57%). Overall, group 2 displays relatively less
second order irrationality than does group 1, a curious result, since
it is precisely group 2 that has the greatest incidence of rst order
irrationality. In group 2, ve respondents answered irrationally to
all three d-contract question groups (8.93% of total respondents),
slightly up on group 1.
As a general conclusion, we can state that second order irra-
tionality, measured as an inconsistent response to a change in loss
amounts when an individual has declared himself to be risk averse,
occurs with a frequency of around about 40% of all questions on
d-contracts, and yet on only about 5% of questions on c-contracts.
Once again, this notable disparity may be due to respondents hav-
ing a greater comprehension of the c-contract format than of the
d-contract format.
We also tested second order irrationality with the answers that
respondents gave on questions 1 and 2. These two questions are
the only questions in the experiment that are actuarially fair, i.e.,
that have a loading factor of 1. From results 5 and 6, we should
expect that any risk averse subject will always choose full coverage
on these contracts. However, second order irrationality under this
test is rampant. The relevant results are presented as columns 9 and
10 of Tables IIIA and IIIB, where the number shown represents the
number of questions (either 0, 1 or 2 for each of the d-contract and
c-contract questions) that were answered inconsistently with risk
aversion. As can be seen, there is an incidence of 0.98 in group 1 and
270 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

0.88 in group 2, of second order irrationality of risk averse subjects
on the c-contract questions of questions 1 and 2, and an incidence
of 0.90 and 0.77 in group 1 and 2, respectively, on the d-contract
questions. Indeed, second order irrationality is so rampant when risk
averse subjects consider actuarially fair contracts, that only three
people responded full coverage on one of the two c-contract ques-
tions in group 1, and only three respondents in group 1 answered
both d-contract questions rationally. In group 1, no respondents at all
answered all four contract choices in questions 1 and 2 rationally. In
group 2, second order irrationality on questions 1 and 2 was slightly
better than in group 1, but it was still surprisingly high. However,
in group 2 there were ve respondents (respondents 1, 4, 10, 12 and
49) who answered all four contract choices consistently with risk
aversion.
We nd the extremely high incidence of second order irrationality
on actuarially fair contract choices to be very difcult to explain.
The fact that the contracts are actuarially fair is really quite evid-
ent upon casual observation of the series of coverage and premium
choices. We also nd it very difcult to explain why several respond-
ents answered the c-contract and the d-contract choices markedly
differently (for example, choosing little or no coverage on one, and
very high or full coverage on the other), for a single risk situation.
Certainly these aspects of the experiment deserve further attention
in future research.
Our third test of second order rationality is the preference of
respondents over the two optimal contract choices for each of the
questions with actuarially loaded premiums. As we state in res-
ult 9, risk averse individuals should always have a preference for
the deductible contract format over all others, including logically,
the c-contract format proposed here. Naturally, given the discrete
nature of the choices that we offered our subjects, we should not
expect that the dominance of the deductible contract format to be
absolute (the choices shown as optimal may be the closest to each
of the theoretical optimums, and yet it is entirely possible that the
c-contract chosen is closer to the theoretical optimum than is the d-
contract chosen). However, we do expect that second order rational
respondents would show a greater frequency of preference for the d-
contract chosen for each risk situation above the chosen c-contract.
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 271
The results of this test are shown in column 11 of Tables IIIA and
IIIB, where we note the number of times that the optimal c-contract
was indicated as being preferred to the optimal d-contract on risk
situations 310 (i.e., eight risk situations in all). Hence, we do not
count situations where the individual indicates indifference between
the two optimal contracts as being irrational.
In group 1, there is an incidence of 0.23 of indicating a strict
preference for the c-contract over the d-contract, while in group 2
the incidence is 0.39 (having eliminated respondent 2). Over the
two groups, we have an aggregate incidence of this type of second
order irrationality of approximately 0.30. That is, close to a third of
all of the preference choices of all individuals over all risk situations
display second order irrationality with respect to the dominance of
the deductible contract format.
5.3. Third order rationality
Our test of third order rationality is given by results 10 and 11.
Depending upon how a respondents d-contract choice responds to
an increase in the large loss, and how his c-contract choice responds
to an increase in the small loss, he manifests the slope of his abso-
lute risk aversion function (assuming he is risk averse hence only
respondent 2 of group 2 has been eliminated). Our rationality test is
simply to require that an implicit manifestation of either DARA or
IARA be consistent over the four possible responses. The relevant
results are reported in Tables IVA and IVB, where D represents
an answer that reveals decreasing absolute risk aversion, and I
represents an answer that reveals increasing absolute risk aversion.
Due to the discrete nature of the questions, we cannot conclude that
a respondent who does not alter his responses necessarily satises
constant absolute risk aversion, and so these answers are simply
indicated by a in the table. Since such an answer is not dir-
ectly inconsistent with either decreasing or increasing absolute risk
aversion, no rationality inferences are drawn from these responses.
There are three tests of third order rationality on c-contracts and one
test of third order rationality on d-contracts.
In group 1 (Table IVA), on the d-contract test, a high proportion
of respondents show decreasing absolute risk aversion (85.71%),
although their responses to the c-contract tests are often inconsistent
272 RICHARD WATT, FRANCISCO J. V

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TABLE IVA
Third Order Rationality, Group 1.
d5,d6 c3,c5 c6,c9 c7,c8
1 D I D D
2 D I D -
3 - D - D
4 D D D -
5 - I I I
6 D D D -
7 D - I D
8 D I D I
9 I I D -
10 D I D I
11 D - - -
12 D - D D
13 D - D D
14 D D I -
15 D - - D
16 D I D D
17 D - D D
18 D D D D
19 D - - D
20 D - D D
21 D I I D
22 D D - I
23 D I D D
24 D I I -
25 D D I -
26 D I D -
27 D - - D
28 I I I D
29 D - D D
30 D I D D
31 - I D -
32 - - - I
33 D - I D
34 D I - I
35 D - - -
36 D - I I
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 273
TABLE IVA
Continued.
d5,d6 c3,c5 c6,c9 c7,c8
37 D D D -
38 D I - I
39 D I I I
40 D - I I
41 - I D I
42 D I I -
43 D D I I
44 D - I I
45 D I I -
46 D I I I
47 D I I I
48 D I D -
49 D D - D
50 D D I I
51 D D I D
52 D D D D
53 D I - -
54 D D D D
55 D I - -
56 D - D D
57 D D I D
58 I D I I
59 D D - I
60 D - D D
61 D I D D
62 D - I I
63 D - I I
64 I D I D
65 D D - I
66 D I I D
67 D D - -
68 D - D D
69 D - I D
70 D I I -
71 I - - I
274 RICHARD WATT, FRANCISCO J. V

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TABLE IVA
Continued.
d5,d6 c3,c5 c6,c9 c7,c8
72 D I - I
73 D - - -
74 D - - D
75 I I - I
76 D I - I
77 D D - I
D 66 21 27 31
I 6 31 27 26
with this. Indeed, 28 respondents (36.36%) show no signs of third
order irrationality (there are not both Ds and Is in their row), while
49 (63.63%) show some sign of third order irrationality. In any case,
the frequency of answers consistent with decreasing absolute risk
aversion is greatly reduced under the c-contract questions, where
only 34.19% of all answers are consistent with DARA.
In group 2 (Table IVB), the results are quite similar those of
group 1. On the d-contract question, 73.21% of respondents answer-
ed consistently with decreasing absolute risk aversion, while only
34.52% of all answers on the c-contract tests are consistent with
DARA. Of the 56 respondents (recall that respondent 2 has been
eliminated since he does not show any signs of risk aversion), 22
(39.29%) show no sign at all of third order irrationality (i.e. there
are not both Ds and Is in their particular row), leaving 34 (60.71%)
with some indication of third order irrationality.
Over all, our results indicate that more than 60% of all respond-
ents display some degree of third order irrationality. Secondly, de-
creasing absolute risk aversion is a far more common characteristic
under d-contracts than under c-contracts.
6. CONCLUSIONS
In this paper we have discussed the results of an experiment that
was carried out in order to attempt to study rationality in insurance
decisions. We divided rationality into three types, in increasing or-
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 275
TABLE IVB
Third order rationality, Group 2.
d5, d6 c3, c5 c6, c9 c7, c8
1 - - - NA
2 D - - -
3 D D - D
4 - - - -
5 D I - -
6 D - D D
7 D D D D
8 D D - I
9 D D D -
10 - - - -
11 - I - -
12 - - - -
13 D - - -
14 I D - D
15 D - D I
16 D D D D
17 D - D D
18 NA D I I
19 D D - -
20 D I D D
21 D I D D
22 - - I -
23 D D - -
24 D I - D
25 - - I D
26 D D D D
27 D D I I
28 D I I I
29 D D I D
30 D - - D
31 D I D -
32 D I D D
33 I D I I
34 - - I I
35 D D D I
36 D I D D
37 D I I I
276 RICHARD WATT, FRANCISCO J. V

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TABLE IVB
Continued.
d5, d6 c3, c5 c6, c9 c7, c8
38 D I I I
39 D I I I
40 D I - D
41 D D D -
42 D D I D
43 D - I I
44 D - - -
45 D I - -
46 I I - D
47 D D I -
48 D D I -
49 - - I -
50 D - I I
51 D I I I
52 D D D -
53 D - D I
54 D I D D
55 - D I I
56 - D D I
57 D I I I
D 42 21 18 19
I 3 18 20 18
ders of sophistication. It must be recalled that, due to the discrete
nature of the choices offered on the experiment, our results can only
ever provide a lower bound to the incidence of irrationality, since
some irrational responses may be disguised in answers that were
not altered in response to a parameter change. In general, the results
from each of two student groups are quite similar, indicating that
there is no real benet from having more time to study insurance
decisions.
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 277
TABLE V
Summary of frequencies of irrationality (average of all respondents).
Irrationality order d-contracts c-contracts Total
(%) (%) (%)
First order irrationality 6.7 10.1 8.4
Second order irrationality
Parameter change 38.1 4.5 29.7
Fair Premium 85.3 94.4 89.8
Preference of d-contract 30.3
Third order irrationality 62.4
Our results conrm the logical ex-ante suspicion that there is gen-
erally greater irrationality on higher orders of sophistication. This is
indicated in Table V, where the irrationality frequencies have been
averaged over both groups of students, and presented as percentage
gures. As one can see from Table V, the degree of irrationality, as
measured by the overall frequency of irrational responses, increases
as the order of rationality tested increases, with the notable excep-
tion of fair premium contract irrationality (second order) which is
far greater than third order irrationality.
Over all, rst order irrationality (answers that are consistent with
negative marginal utility) is present in 8.4% of all responses, a result
that may be due to misunderstanding of the basic implications of
the insurance contract formats offered. Our second order rational-
ity results are very dependent on both the contract format, and on
the loading factor in the premium. On loaded premium contracts,
second order irrationality is present in only 4.5% of the d-contract
responses, but on about 38.1% of the responses on c-contracts. That
is, second order irrationality is about eight times more frequent on
contracts with an upper limit on the coverage than on deductible
contracts. Over both contract types, second order irrationality under
a parameter change is present in 29.7% of all answers.
Perhaps our most surprising result, however, is the rampant ex-
istence of second order irrationality (on both contract types) when
actuarially fair contracts are considered. On this type of contracts,
second order irrationality is present in 89.8% of all responses. Once
278 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

again, this type of second order irrationality is more frequent in c-
contracts (94.4%) than in d-contracts (85.3%), although they are
much more similar gures than for parameter change second order
irrationality.
Within the general idea of second order rationality, we also tested
for the dominance of the deductible contract format. 30.3% of all
respondents displayed a strict preference for the upper limit contract
over the deductible contract, in contradiction to the theoretically ex-
pected result (note that this is a very similar degree of irrationality
to the average of second order irrationality for parameter changes
(29.7%), which is logical since both are tests of second order ration-
ality). However, on one hand, some irrationality may be hidden in
answers for which no strict preference was stated (i.e., the respond-
ent answered that he/she was indifferent between the two contract
types), it is also true that the discrete nature of the contract choices
may result in the best c-contract being closer to the theoretical op-
timum than the best d-contract. Hence, it becomes possible that,
even if the theoretically optimal c-contract is inferior to the theoret-
ically optimal d-contract, the best c-contract option turns out to be
better than the best d-contract option.
Finally, we tested for third order irrationality, which is dened as
inconsistent manifestations of the slope of the ArrowPratt meas-
ure of absolute risk aversion. Here, we nd that DARA is far more
frequent on d-contracts than on c-contracts, and that there is some
degree of irrationality (that is, inconsistencies) on 62.4% of all re-
spondents answers, a higher frequency than both of the other orders
of irrationality with the exception of fair premium second order
irrationality.
Naturally, all of our results concerning irrationality can be ex-
plained by removing the underlying assumptions, for example ex-
pected utility, and the monotonicity assumption placed on the second
derivative of the utility function. It is well known that experimental
evidence is not very supportive of the expected utility assumption
[see, for a very recent example, Sopher and Narramore (2000)],
upon which our expected results are based. However, at least one
of our results does not depend on expected utility (the dominance
of the deductible contract format), and it is very likely that all our
rst and second order rationality tests can also be cast in terms of
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 279
rst and second order stochastic dominance also, thereby admitting
a far wider range of preference functions. In any case, it is import-
ant to realise that our ambitions in the experiment were not to test
expected utility as a descriptive theory, but rather to consider devi-
ations from rational behaviour, in order to point out where normative
suggestions that curb behaviour might be directed.
ACKNOWLEDGEMENT
This research was supported by CICYT project no. PB-98-0059.
7. APPENDIX 1: INSTRUCTIONS FOR PARTICIPANTS
You have been selected to participate in an experiment related to
the design of insurance contracts. We thank you very much for your
collaboration, and we hope that you think seriously about each of
the situations that the experiment contains. To that end, a PRIZE
of 200 000 pesetas will be awarded to the participant whose an-
swers contain the least number of logical inconsistencies. Hence,
your best strategy is to answer each situation according to your
true preferences. Please read these instructions carefully before
proceeding.
The experiment contains 10 risk situations that you must think
about, and for which you are offered insurance. In each risk situ-
ation, you can suffer one of two possible losses, a small loss (which
is sometimes equal to 0), and a large loss. The respective probab-
ilities of each of the two losses are indicated in percentage terms,
that is, if a given loss happens with probability 0.7, then this is
indicated by the statement that the loss occurs with a probability
of 70%. Of course, you should never think that it is ever possible to
suffer, simultaneously, both losses, i.e., only one of the two losses
will occur, either the small one or the large one.
For each situation, you are offered two insurance tables, with
different contract formats, that enable you to reduce the risk of the
situation. The table on the left hand side of the page represents
insurance contracts with a deductible, that is, you limit your max-
imum loss amount to the deductible chosen, plus the corresponding
280 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

premium. For example, consider situation 5. If you choose (from the
left hand table), a deductible of 20 000 pesetas, and the loss turns
out to be 70 000 pesetas (this occurs with a probability of 30%),
then you will loose only 20 000 pesetas, while the (hypothetical)
insurance company will be responsible for the other 50 000 pesetas.
On the other hand, if the loss turns out to be 10 000 pesetas (this
occurs with a probability of 70%), then you alone will loose 10 000
pesetas. In either case (that is, independently of the nal value of the
loss), bear in mind that you will also be charged the corresponding
premium, which in the case of a 20 000 peseta deductible is 16 500
pesetas.
The table on the right represents the case of insurance contracts
with an upper limit on coverage (that is, you get a minimum limit to
your own loss). For example, consider once again situation 5. If you
choose (in the right hand table) a coverage of 20 000 pesetas, and
the loss turns out to be 70 000 pesetas, then you will be responsible
for 50 000 pesetas and the other 20 000 pesetas (your coverage)
will be paid by the insurer. On the other hand, if the loss turns out
to be 10 000 pesetas, since this is below your coverage limit, you
will suffer no loss at all, and the insurer will be responsible for the
10 000 peseta loss. Once again, bear in mind that in either case, you
must pay the corresponding premium, which is 14 300 pesetas for a
coverage of 20 000 pesetas.
For each situation, you must choose the insurance option that you
most prefer from both tables (choose the best one fromthe left hand
table, and the best one fromthe right hand table). Please indicate you
choices by enclosing the preferred option in a circle. Once you have
chosen the best option from each table, please then indicate which
of these two preferred options is the overall preferred choice by
placing an asterix beside the overall preferred option. If you happen
to be indifferent between the most preferred option in each table,
please indicate this by placing an asterix beside both of the circled
options.
As an example, assume that in situation 3 you prefer a deductible
of 30 000 pesetas in the left hand table and a coverage of 20 000
pesetas in the right hand table, and then between these two options,
your overall preferred choice is the coverage contract, then your
questionnaire should appear marked as follows:
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 281
SITUATION 1
In this situation, there is an 80% probability of suffering a loss
of 0 pesetas, and a 20% probability of suffering a loss of 140 000
pesetas.
Table 1.1 Table 1.2
0 28 000 0 0
10 000 26 000 10 000 2 000
20 000 24 000 20 000 4 000
30 000 22 000 30 000 6 000
40 000 20 000 40 000 8 000
50 000 18 000 50 000 10 000
60 000 16 000 60 000 12 000
70 000 14 000 70 000 14 000
80 000 12 000 80 000 16 000
90 000 10 000 90 000 18 000
100 000 8 000 100 000 20 000
110 000 6 000 110 000 22 000
120 000 4 000 120 000 24 000
130 000 2 000 130 000 26 000
140 000 0 140 000 28 000
282 RICHARD WATT, FRANCISCO J. V

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SITUATION 2
In this situation, there is a probability of 80% of suffering a loss
of 20 000 pesetas, and a probability of 20% of suffering a loss of
140 000 pesetas.
Table 1.1 Table 1.2
0 44 000 0 0
10 000 34 000 10 000 10 000
20 000 24 000 20 000 20 000
30 000 22 000 30 000 22 000
40 000 20 000 40 000 24 000
50 000 18 000 50 000 26 000
60 000 16 000 60 000 28 000
70 000 14 000 70 000 30 000
80 000 12 000 80 000 32 000
90 000 10 000 90 000 34 000
100 000 8 000 100 000 36 000
110 000 6 000 110 000 38 000
120 000 4 000 120 000 40 000
130 000 2 000 130 000 42 000
140 000 0 140 000 44 000
SITUATION 3
In this situation, there is a probability of 70% of suffering a loss
of 0 pesetas, and a probability of 30% of suffering a loss of 70 000
pesetas.
Table 3.1 Table 3.2
0 23 100 0 0
10 000 19 800 10 000 3 300
20 000 16 500 20 000 6 600
30 000 13 200 30 000 9 900
40 000 9 900 40 000 13 200
50 000 6 600 50 000 16 500
60 000 3 300 60 000 19 800
70 000 0 70 000 23 100
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 283
SITUATION 4
In this situation, there is a probability of 90% of suffering a loss
of 0 pesetas, and a probability of 10% of suffering a loss of 70 000
pesetas.
Table 4.1 Table 4.2
0 7 700 0 0
10 000 6 600 10 000 1 100
20 000 5 500 20 000 2 200
30 000 4 400 30 000 3 300
40 000 3 300 40 000 4 400
50 000 2 200 50 000 5 500
60 000 1 100 60 000 6 600
70 000 0 70 000 7 700
SITUATION 5
In this situation, there is a probability of 70% of suffering a loss
of 10 000 pesetas, and a probability of 30% of suffering a loss of 70
000 pesetas.
Table 3.1 Table 3.2
0 30 800 0 0
10 000 19 800 10 000 11 000
20 000 16 500 20 000 14 300
30 000 13 200 30 000 17 600
40 000 9 900 40 000 20 900
50 000 6 600 50 000 24 200
60 000 3 300 60 000 27 500
70 000 0 70 000 30 800
284 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

SITUATION 6
In this situation, there is a probability of 70% of suffering a loss
of 10 000 pesetas, and a probability of 30% of suffering a loss of
140 000 pesetas.
Table 6.1 Table 6.2
0 53 900 0 0
10 000 42 900 10 000 11 000
20 000 39 600 20 000 14 300
30 000 36 300 30 000 17 600
40 000 33 000 40 000 20 900
50 000 29 700 50 000 24 200
60 000 26 400 60 000 27 500
70 000 23 100 70 000 30 800
80 000 19 800 80 000 34 100
90 000 16 500 90 000 37 400
100 000 13 200 100 000 40 700
110 000 9 900 110 000 44 000
120 000 6 600 120 000 47 300
130 000 3 300 130 000 50 600
140 000 0 140 000 53 900
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 285
SITUATION 7
In this situation, there exists a probability of 80% of suffering a
loss of 10 000 pesetas, and a probability of 20% of suffering a loss
of 140 000 pesetas.
Table 7.1 Table 7.2
0 39 600 0 0
10 000 28 600 10 000 11 000
20 000 26 400 20 000 13 200
30 000 24 200 30 000 15 400
40 000 22 000 40 000 17 600
50 000 19 800 50 000 19 800
60 000 17 600 60 000 22 000
70 000 15 400 70 000 24 200
80 000 13 200 80 000 26 400
90 000 11 000 90 000 28 600
100 000 8 800 100 000 30 800
110 000 6 600 110 000 33 000
120 000 4 400 120 000 35 200
130 000 2 200 130 000 37 400
140 000 0 140 000 39 600
286 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

SITUATION 8
In this situation, there is a probability of 80% of suffering a loss
of 20 000 pesetas, and a probability of 20% of suffering a loss of
140 000 pesetas.
Table 8.1 Table 8.2
0 48 400 0 0
10 000 37 400 10 000 11 000
20 000 26 400 20 000 22 000
30 000 24 200 30 000 24 200
40 000 22 000 40 000 26 400
50 000 19 800 50 000 28 600
60 000 17 600 60 000 30 800
70 000 15 400 70 000 33 000
80 000 13 200 80 000 35 200
90 000 11 000 90 000 37 400
100 000 8 800 100 000 39 600
110 000 6 600 110 000 41 800
120 000 4 400 120 000 44 200
130 000 2 200 130 000 46 200
140 000 0 140 000 48 400
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 287
SITUATION 9
In this situation, there is a probability of 70% of suffering a loss
of 20 000 pesetas, and a probability of 30% of suffering a loss of
140 000 pesetas.
Table 9.1 Table 9.2
0 61 600 0 0
10 000 50 600 10 000 11 000
20 000 39 600 20 000 22 000
30 000 36 300 30 000 25 300
40 000 33 000 40 000 28 600
50 000 29 700 50 000 31 900
60 000 26 400 60 000 35 200
70 000 23 100 70 000 38 500
80 000 19 800 80 000 41 800
90 000 16 500 90 000 45 100
100 000 13 200 100 000 48 400
110 000 9 900 110 000 51 700
120 000 6 600 120 000 55 000
130 000 3 300 130 000 58 300
140 000 0 140 000 61 600
288 RICHARD WATT, FRANCISCO J. V

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SITUATION 10
In this situation, there is a probability of 90% of suffering a loss
of 20 000 pesetas, and a probability of 10% of suffering a loss of
140 000 pesetas.
Table 1.1 Table 1.2
0 35 200 0 0
10 000 24 200 10 000 11 000
20 000 13 200 20 000 22 000
30 000 12 100 30 000 23 100
40 000 11 000 40 000 24 200
50 000 9 900 50 000 25 300
60 000 8 800 60 000 26 400
70 000 7 700 70 000 27 500
80 000 6 600 80 000 28 600
90 000 5 500 90 000 29 700
100 000 4 400 100 000 30 800
110 000 3 300 110 000 31 900
120 000 2 200 120 000 33 000
130 000 1 100 130 000 34 100
140 000 0 140 000 35 200
8. APPENDIX 2: PROOFS OF RESULTS OF SECTION 4
For convenience, we shall present the proofs of the results in the
following order; rstly we prove all results concerning the choice
of an optimal deductible, and then the results concerning the choice
of optimal coverage. In order to avoid all confusions, all proofs are
preceded by its corresponding result, repeated from the text.
8.1. Results concerning deductible contracts
For deductible contracts, the premium can be expressed as:
(, d) =

[pL
2
+ (1 p)L
1
d] d L
2
(1 p)(L
1
d) L
2
< d < L
1
0 d L
1
(1)
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 289
and expected utility is:
EU(d) =

u(w (d) d) d L
2
pu(w (d) L
2
) + (1 p)u(w (d) d) L
2
< d < L
1
pu(w L
2
) + (1 p)u(w L
1
) d L
1
(2)
RESULT 1. Assuming > 1, the optimal deductible will always
satisfy d

> L
2
.
Proof. From (1), for all d L
2
, we have:

d
= (3)
Marginal utility in this case is:
u

(w(, d)d)

d
1

= u

(w(, d)d)(1)
which is necessarily positive under the assumption of positive mar-
ginal utility, since > 1. Therefore expected utility is increasing for
all deductible values less than or equal to the small loss, implying
that no such deductible can ever be optimal.
Now consider contracts with a deductible that satises L
2
< d <
L
1
. For such contracts, the marginal premium is:

d
= (1 p) (4)
The marginal utility of such a contract is given by:
EU

(d) = (1 p)[pu

(a) u

(b)(1 )1 p))] (5)

where:
a w (1 p)(L
1
d) L
2
b w (1 p)(L
1
d) d
Since we are assuming d > L
2
, it holds that a > b.
290 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

RESULT 3. Assuming > 1, if the optimal deductible is less than
the large loss value, that is, d

< L
1
, then the individual must be
risk averse, i.e. u

(x) < 0.
Proof. Assume that the individual is either risk neutral or risk
loving, i.e. u

(x) 0. Since a > b, we would have u

(a) u

(b).
Hence, in this case the rst derivative of expected utility satises:
EU

(d) (1 p)u

(b)[p
(1 (1 p))] = (1 p)u

(b)( 1) > 0
In this case, the optimal solution is to set the deductible equal to the
large loss, that is, no insurance is purchased.
Given that an internal solution is inconsistent with either risk
neutral or risk loving preferences, and the assumption that the second
derivative of utility has monotone slope, the only option that can
admit an internal solution, that is d

< L
1
, is a concave utility
function, u

(x) < 0.
Given an internal solution, the second derivative of expected util-
ity is:
EU

(d) = pu

(a)((1 p))
2
+ (1 p)u

(b)((1 p) 1)
2
< 0
hence the rst order condition for an optimum in this case is given
by EU

(d

) = 0. Dene
h(p, , L
1
, L
2
, d

) pu

(a

) u

(b

)(1 (1 p)) (6)

so that the rst order condition is where h() = 0, or:
=
u

(b

)
pu

(a

) + (1 p)u

(b

)
(7)
RESULT 5. If the individual is risk averse, and if = 1, then the
optimal solution is to set the deductible equal to the small loss, that
is, full coverage is purchased.
Proof. From Equation (7), given = 1, we have pu

(a

) + (1
p)u

(b

) = u

(b

), that is u

(a

) = u

(b

). Since we are assuming

that the utility function is concave, it holds that a

= b

.
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 291
We nowgo on to consider the effects of changes in the underlying
parameters on the optimal deductible, assuming risk aversion and
loaded premiums. To do so, we make use of the implicit function
theorem, which can be stated as:
d

y
=

2
EU
d

2
EU
(d

)
2
(8)
where y can be any of the parameters , p, L
1
and L
2
. Since, given
risk aversion, expected utility is strictly concave in the optimal de-
ductible (8), indicates that the sign of the effect of the change in the
parameter on the optimal deductible is the same as the sign of the
cross derivative of expected utility (the numerator of (8)). However,
the sign of this cross derivative is equal to the sign of h/y.
The following corollary will also be useful throughout some of
the next results:
COROLLARY 1. If the utility function displays decreasing (increas-
ing) absolute risk aversion, then:
u

(b

) < (>)(pu

(a

) + (1 p)u

(b

)) (9)
Proof. Using (7), Eq. (9) can be written as:
u

(b

)(pu

(a

) + (1 p)u

(b

)) < (>)u

(b

)
(pu

(a

) + (1 p)u

(b

))
Subtracting (1 p)u

(b

)u

(b

) from each side, and dividing by p

yields:
u

(b

)u

(a

) < (>)u

(b

)u

(a

)
which rearranges directly to:

(b

)
u

(b

)
> (<)
u

(a

)
u

(a

)
Finally, recalling that a

> b

, we have decreasing (increasing)

absolute risk aversion.
Of course, under constant absolute risk aversion (9) would hold
with equality. However, given the fact that subjects in the experi-
ment were not given a continuous choice of insurance contracts, an
292 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

individual that does not alter his optimal choices of deductible does
not reveal information as to his true underlying risk preference.
RESULT 7. If the individual is risk averse, and if > 1, then an
increase in the small loss, L
2
, will increase the optimal deductible,
d

/L
2
> 0.
Proof. Since b

is independent of L
2
, and a

= w(1p)(L
1

) L
2
, the sign of the effect of an increase in the small loss on
the optimal deductible is the same as:
h
L
2
= pu

(a

) > 0
RESULT 10. If the individual is risk averse, and if > 1, then if
an increase in the large loss L
1
has the effect of decreasing (increas-
ing) the optimal deductible for a risk averse subject, then the utility
function satises decreasing (increasing) absolute risk aversion.
Proof. If an increase in L
1
has the effect of decreasing (increas-
ing) the optimal deductible, then it must hold that:
h
L
1
< (>)0
From (6):
h
L
1
= (1 p)[pu

(a

) (1 (1 p))u

(b

)]
Hence:
h
L
1
< (>)0 as pu

(a

) (1 (1 p))u

(b

) > (<)0
that is:
h
L
1
< (>)0 as [pu

(a

) + (1 p)u

(b

)] > (<)u

(b

)
Hence, from corollary 1, it holds that the utility function displays
DARA (IARA).
AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 293
8.2. Expected results with upper limit contracts
For upper limit contracts, the premium can be expressed as:
(, c) =

c c L
2
[pL
2
+ (1 p)c] L
2
< c < L
1
[pL
2
+ (1 p)L
1
] c L
1
(10)
and the expected utility is:
EU(c) =

pu(w (c) L
2
+ c) + (1 p)u(w (c) L
1
+ c) c L
2
pu(w (c)) + (1 p)u(w (c) L
1
+ c) L
2
< c < L
1
u(w (c)) c L
1
(11)
RESULT 2. No interior solution with 0 < c L
2
exists if > 1.
Proof. Marginal utility with c L
2
is:
EU

(c) = (pu

(w c L
2
+ c) + (1 p)u

(w c L
1
+ c))( 1)
which, with > 1, is strictly negative, implying that c = 0 gives
greater expected utility than any other value of c that satises 0 <
c L
2
.
Now consider contracts such that c L
2
, for which marginal
expected utility is:
EU

(c) = (1 p)[pu

(a) + (1 (1 p))u

(b)] (12)
where:
a w (pL
2
+ (1 p)c)
b w (pL
2
+ (1 p)c) L
1
+ c
Note that since c < L
1
, it holds that a > b.
RESULT 4. If > 1, and the optimal coverage satises c

> L
2
,
then the subject is risk averse, i.e., u

(x) < 0.
Proof. Assume that the individual is either risk neutral or risk
loving, so that u

(x) 0. Since a > b, we would have u

(a)
294 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

u

(b). In this case, marginal utility (Equation (12)) satises:

EU

(c) (1 p)u

(a)[p + (1 (1 p)] = (1 p)u

(a)(1 ) < 0
Hence the expected utility of risk neutral or risk loving subjects has
negative slope over the range L
2
< c < L
1
. Together with result 2,
the implication is that for these individuals c

= 0, i.e., no coverage
is purchased.
Since an interior solution cannot be supported by risk neutral
or risk averse preferences, it can only correspond to risk averse
preferences.
If utility is concave, then:
EU

(c) = ((1 p))

2
pu

(a) +
(1 (1 p))
2
(1 p)u

(b) < 0
in which case the rst order condition for an optimal solution is:
g(L
1
, L
2
, p, ) pu

(a

) + (1 (1 p))u

(b

) = 0
(13)
Given (13), we can directly state that, any interior solution must
satisfy Equation (7), with the relevant substitutions for a

and b

.
RESULT 6. If = 1, a risk averse individual will set the optimal
coverage equal to the large loss, c

= L
1
.
Proof. Directly from (7) with = 1 it must hold that:
u

(b

) = pu

(a

) + (1 p)u

(b

) u

(a

) = u

(b

)
Since the utility function is strictly concave, it must hold that a

=
b

, that is c

= L
1
.
RESULT 8. If the individual is risk averse and if > 1, an increase
in the large loss will increase the amount of coverage in an interior
solution, c

/L
1
> 0.
Proof. The implied cross derivative is:
g
L
1
= u

(b

)(1 (1 p)) > 0

AN EXPERIMENT ON RATIONAL INSURANCE DECISIONS 295
where the inequality direction is due to the fact that in an interior
solution, from (13) it holds that:
1 (1 p) =
pu

(a

)
u

(b

)
> 0
RESULT 11. If the individual is risk averse, and if > 1, then if an
increase in the small loss has the effect of increasing (decreasing)
the optimal coverage, then the utility function displays decreasing
(increasing) absolute risk aversion.
Proof. If an increase in L
2
increases (decreases) the optimal cov-
erage, then it must hold that:
g
L
2
> (<)0
However:
g
L
2
= p[u

(a

) + (1 (1 p))u

(b

)]
Hence:
g
L
2
> (<)0 as pu

(a

) + (1 (1 p))u

(b

) < (>)0
That is:
g
L
2
> (<)0 as u

(b

) < (>)[pu

(a

) + (1 p)u

(b

)]
Therefore, from Corollary 1, we have DARA (IARA).
REFERENCES
Arrow, K. (1963), Uncertainty and the welfare economics of medical care,
American Economic Review, December 1963, 941969.
Arrow, K. (1971), Essays in the Theory of Risk Bearing. Chicago: Markham.
Gollier, C. and Schlesinger, H. (1996), Arrows theorem on the optimality of
deductibles: A stochastic dominance approach, Economic Theory, 7, 359363.
Schoemaker, P. and Kunreuther, H. (1979), An experimental study of insurance
decisions, Journal of Risk and Insurance, 46: 603618.
296 RICHARD WATT, FRANCISCO J. V

AZQUEZ AND IGNACIO MORENO

Shopher, B. and Narramore, J. (2000), Stochastic choice and consistency in de-
cision making under risk: An experimental study, Theory and Decision 48,
323350.
von Neumann, J. and Morgenstern, O. (1944), Games and Economic Behavior,
Princeton University Press, Princeton, NJ.
Addresses for correspondence: Richard Watt, Dept. Anlisis Econmico, Fac.
C.C.E.E., Universidad Autnoma de Madrid, Ctra. Colmenar, Km 15, Madrid
28049, Spain
Phone: +34-91-3974318; Fax: +34-91-3978616; E-mail: richard.watt@uam.es