Survival risks, intertemporal consumption, and insurance: the case of distorted probabilities
Insurance: Mathematics and Economics , Volume 38 - Issue 2 p. 335- 346
This paper explores how to evaluate changes in survival probabilities when people do not process probabilities linearly, as is commonly assumed in the literature, but distort probabilities. We show that the valuation of risks to life depends critically on two parameters: the elasticity of the probability weighting function and the elasticity of the utility function with respect to future consumption. Using estimates from the empirical literature we derive that the bias of erroneously ignoring probability distortion in general leads to cost–benefit ratios that are too high and that generate too much priority for programs that save young lives.
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Bleichrodt, H, & Eeckhoudt, L. (2006). Survival risks, intertemporal consumption, and insurance: the case of distorted probabilities. Insurance: Mathematics and Economics, 38(2), 335–346. doi:10.1016/j.insmatheco.2005.09.004