Insight: Using Prospect Theory to Explain Annuity and Insurance Market Puzzles
By Jason Fichtner
IDEAS IN THIS INSIGHT YOU CAN PUT INTO ACTION
Daniel Gottlieb’s research findings suggest the following: (1) Potential retirement investors’ aversion to losing their investment in an annuity (known as loss aversion) may explain the under-annuitization of wealth by consumers, because they are concerned they might die soon after purchase, and so have experienced a financial loss. (2) Loss aversion may also explain why working-age consumers purchase insufficient amounts of life insurance. (3) The puzzle of why elderly people hold too much life insurance may be explained by their risk-seeking behavior with losses—that is, they accept greater volatility and uncertainty with investments in exchange for a higher expected return because they want to try to recoup losses. This is particularly true for those who have held their insurance policies for many years and so have invested a large amount of money in their purchase. (4) Risk-seeking behavior with losses may prevent individuals from liquidating their life insurance (which pays beneficiaries only when the insurance owner dies), even when they have purchased an annuity (which pays as long as the annuity owner lives), if they are loss averse and the fees charged for the purchase of an annuity are not too large. (5) Demand for annuities with guarantees, such as a guarantee to make annuity payments for a certain period, or refund options may also be explained by consumer loss aversion. Based on the author’s findings, we suggest the exploration of a hybrid product that provides consumers with life insurance when they are working age, and then converts to an annuity later in life, when the consumer retires.
Read the Full Insight
About the Author
Jason J. Fichtner is Chief Economist at the Bipartisan Policy Center and Senior Fellow at the Retirement Income Institute.