Insuring against losses of property and life is inconsistent with buying lotteries and visiting casinos.

Critically discuss this statement. ! To understand the paradox why an individual may purchase insurance (thus displaying a dislike for risk) and at the same time visit a casino or purchase a lottery ticket (displaying a risk taking behavior), it is important to differentiate the different type of individuals concerning their appetite for risk. In essence, we have three type of individuals - risk neutral, risk averse and risk loving. ! The utility theory can be used to differentiate individual appetite for risk. This theory attempts to explain the relation between wealth or consumption with the satisfaction derived in some utility units. The underlying assumptions when using this theory are threefold. The rst is that more is always preferred to less for all levels of consumption or wealth. The second is that the extra utility will get smaller as wealth increases - the idea of diminishing marginal utility. The third is that the individual will always benet from extra wealth, there is no limiting point where he/she will have enough - this is non-satiation. This can be shown graphically by a utility function. Risk neutral individuals have a straight, upward sloping utility function. Any increase in wealth will give the individual an equal increase in utility and these individuals are indifferent to taking fair bets. Risk averse individuals have a concave, upward sloping utility function. This implies that increases in wealth will give a decreasing utility and the individual will always reject a fair bet. Risk loving individuals have convex, upward sloping utility functions. They will always take on fair bets because the extra satisfaction increases with the increase in wealth. ! Insurance is described in the Oxford Dictionary of economics as the use of contracts to reduce and redistribute risk. Using the utility theory, we can show that the different type of individuals described above will have different choices when it comes to insure or not insure. Suppose that an individual buys an iPhone for RM1200 and has an option to insure it against any damages. The chances of the iPhone getting damaged are 15% and would reduce its value to a mere RM100. The loss from damage is therefore RM1100. If the insurance is fairly priced at RM165 (RM1100*15%), the gures below illustrate how the individuals would make their choices. Utility of Wealth

U(RM1200) U(RM1035)

U(RM100) 100 Wealth (RM) 1035 1200

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The above gure is the utility function for a risk neutral individual. The expected utility without insurance is U(RM1035) = (RM1200*85% + RM100*15%) which is exactly the same as the utility he derives with insurance. This individual would be indifferent to buying the insurance as essentially the risk has no value to him. Utility
U(RM1035)w.i. U(RM1035) w.o.i

U(RM100)

Wealth (RM) 100 1035 1200

! The above diagram depicts the situation for a risk averse individual. This individual will take insurance because the utility derived even after paying the premium of RM165 is greater the expected utility without insuring the iPhone. Utility

U(RM1200)

U(RM1035) w.o.i

U(RM1035)w.i.

U(RM100)

100

1035

1200

Wealth (RM)

! For the risk lover, clearly he is better off not insuring, and he will not insure. The utility he gets from not insuring is U(RM1035) is much higher than the expected utility he gets from buying the insurance. In other words, he derives more satisfaction from leaving his iPhone in a combination of the chances of it retaining its value of RM1200 and reducing to RM100 than parting with RM165 to a certainty of being insured fully.
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! A risk averse individual will always reject a fair gamble. A risk lover will always take a fair gamble. A risk averse individual will always take a fairly priced insurance. A risk lover will always reject a fairly priced insurance. The observation in casinos is that some people can be risk averse and risk lovers at the same time, which may seem as an inconsistency in the theory. However, Friedman & Savage (1948) came up with the S-shaped utility function to explain this inconsistency. ! The idea behind this is quite straightforward. Instead of limiting one individual to only one class of risk appetite, it makes sense to assume a single individual can in different circumstances be in more than one class of risk appetite. In other words, an individual can be both risk averse and risk loving at the same time, with some qualications. Consider the S-shaped utility function below.

Key: A = RM5000 X = RM10000 D = RM14000 Z = RM18000! ! The individual is currently at point X with wealth amounting to RM10000. At this level of wealth below down to 0, the individuals utility function is concave and implies risk aversion. In this case, there is an equal chance of him retaining his wealth at RM10000 or losing it all to RM0. An insurance company offers to sell him a guarantee that his wealth will not fall below RM5000 (point A). We assume that the insurance company has priced the premium fairly at RM5000 (0.5*10000 + 0.5*0). Will he accept the offer? The utility he derives from keeping his wealth at RM10000 is U(X) and is the highest utility he can get from this section of the curve. If he doesnt accept the offer, there is a 50% chance of him enjoying this high U(X) and an equal chance of him suffering U(0) in the event all his
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wealth is lost. To improve this situation, he will accept the offer from the insurance company. The utility he derives from insuring and guaranteeing his wealth to remain at point A is U(A) and is much higher than leaving it to chance at point E(U(A)). ! Now suppose that the same individual walks into a casino and is contemplating on taking on a gamble that will possibly increase his wealth by Z-X (RM8000). There is an equal chance of the gamble ending up with an RM8000 win or a total loss. The entry price of the gamble is fair at RM4000 (0.5*8000+0.5*0). Will the individual take on the gamble? Observing the curve, we see that when the wealth level is above X (RM10000), the utility curve is now convex which means that there is an increasing marginal utility of wealth and a risk loving attitude. If the individual doesnt take the gamble, he will keep his RM4000 and his total wealth will remain at D (RM14000). However, at point D the expected utility E (U(D)) from taking the gamble is above the utility U(D) he derives from keeping his wealth with certainty at D. So in this case, the individual will take on the gamble. ! Thus it is consistent for an individual to purchase insurance and gamble. The expected utility theory isnt the only explanation of this and has been criticized over the years. Basili (1999) argues that the expected utility theory combines linearity in utility and probability and maximization of the expected utility as a criterion of choice among alternatives involving risk fails to explain the existence of both insurance and lotteries. ! ! The prospect theory put forth by Kahneman and Tversky (1979) can also explain this inconsistency. One aspect of this theory is on the weighting of probabilities. The proposal made is that very low probabilities are generally overweighted (p281). In the context of gambles, we nd that an individual puts a higher weight on the remote probability of winning the gamble in the casino and would therefore be likely to purchase the ticket. At the same time, the individual puts a higher weight on the small chance of his house catching a re and would therefore purchase the insurance. ! Another aspect of the prospect theory is framing effects (Kahneman & Tversky, 1981). An individuals decision making involving risk is inuenced by the context in which the decision is framed. This quite relevant in situations where the probabilities are at the extremes. Observe the illustrations below:

Fig. 1 Lottery Poster

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! The Ohio lottery poster is presented above. The chances of winning this lottery are very slim. However, millions of people would still buy the ticket which costs $2. Here, an individual is looking at the prospect of him winning the lottery and a free $10,000 every year for the rest of his life. This is because the framing of the message is very positive and it results in individuals putting a much higher weight on the small probability of winning and thus buys the ticket.
More than just a house, your home is where the heart is. It is where you have invested a lot of time, effort and money. However, it could be ruined overnight due to burglary, re or natural disasters. While heartache may be unavoidable, you can control your nancial losses with our Home Contents coverage. Coverage: This is pre written package covering your basic household items as follows Sofa, dining set Fans, air-conditioners, light ttings Refrigerator, washing machine, microwave oven, kitchen electrical appliances TV, VCD/VCR (excluding Astro Dish and decoder), Hi-, audio visual accessories Beds and mattresses Desktop computers excluding laptops, PDAs, cameras and video cameras Even spoilage of perishables in refrigerators due to an insured peril and loss of cash due to re or forcible theft is covered under this plan. Insured Perils: Fire; lightning; explosion; aircraft damage; impact damage; theft; resultant damage caused by bursting or overowing of domestic water tanks, apparatus or pipes; and windstorm. Benets: Replace damaged or lost electrical appliances with new ones. No average clause i.e. we will not penalize you for any under insurance

Fig 2. Chartis Home Contents Insurance ! ! The gure above shows a typical home contents insurance. Paying attention to the words bolded, we nd that the context of framing of the insurance is very negative. The same individual who purchased lottery described earlier is inuenced by the fact that his house could be ruined overnight due to burglary, re or others. Although the probability of such events is less than 5%, the framing context will lead to the individual to put a much higher weight on the probability event and therefore be likely to purchase insurance to control nancial losses as highlighted above. ! Thus a combination of overweighting low probabilities, framing effects and the fact that individuals place more value on gains than losses explain the joint occurrence of gambling and insurance. ! Another theory to explain this anomaly is put forth by Harbaugh and Kornienko (2001). In the theory, a model linking local status and utility is developed. An individual will always have a reference group with which to compare their wealth. If this reference groups average wealth level is higher than the individuals, the individual is more likely to undertake a gamble that has a payoff exceeding that wealth level. On the contrary, it is found that if the reference group has a lower average wealth than the individual, the
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individual is likely to buy insurance which prevents wealth from falling below that level. The same individual could have multiple reference groups, some with a lower level of wealth and others with a higher level of wealth. In this case, the individual would be seen purchasing insurance and participating in gambles simultaneously. ! Thaler and Johnsons house-money effect and snake-bit effect proposition in 1990 can also give an insight into the insurance gambling issue. The house money effect suggests that people are more inclined to take on risky bets after experiencing a gain. The snake-bit effect suggests that people are more likely to be risk averse after suffering a loss. An individual, having won money unexpectedly, is more likely to be seen in the casino gambling it away. However, if the same individual has suffered a loss in a near period, he is more likely to purchase insurance to avoid the pain of further losses. Therefore it is not uncommon to see an individual who has purchased insurance to reduce losses when they occur, going to a casino to gamble when there is an increase in his wealth. ! In conclusion, insurance and gambling are not inconsistent. There are a multitude of theories available to reconcile these. Every theory has some weaknesses due to the complexity of modeling human behavior. They all show that these two can coexist. The most accepted ones are the seminal work of Friedman and Savage and later of Tversky and Kahneman. The other theories all give an insight, but they in a way or another base their arguments upon modifying the mentioned works. Word Count: 1924 !

Bibliography
Basili, M. and Fontini, F. (2000) Choices under Risk and Uncertainty with Windfall Gains and Catastrophic Losses, Quaderni del Dipartimento di Economia Politica, 306(1). Chartis Insurance (2009) Personal Insurance, [online] Available at: http:// www.chartisinsurance.com.my/Chartis/en/per/home-content.html [Accessed: 6th Dec 2011]. Friedman, M. and Savage, L. (1948) The Utility Analysis of Choices Involving Risk, Journal of Political Economy, 56(4). Kahneman, D. and Tversky, A. (1979) Prospect Theory: An Analysis Of Decision Under Risk, Econometrica, 47(2). Kornienko, T. and Harbaugh, R. (2000) Local Status and Prospect Theory, Claremont Colleges Working Papers, 2000(38). Ohio State Lottery (2010) Win for Life with the Ohio Lottery's "It's a Wonderful Life" instant ticket. [image online] Available at: http://ohiolotterykenotes.les.wordpress.com/ 2010/11/10-its-a-wonderful-life-scene-2.jpg?w=300&h=300 [Accessed: 7th Dec 2011]. Thaler, R. and Johnson, E. (1990) Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice, Management Science, 36(6). Tversky, A. and Kahneman, D. (1981) The Framing of Decisions and the Psychology of Choice, Science, 211(4481).