Because choosing insurance requires consumers to assess risks and probabilities, the demand for insurance has proven to be fertile ground for identifying deviations from rational behavior. Consumers often shun the insurance against large losses that they rationally should want (e.g., floods); and they are attracted to insurance against small losses (extended warranties, low deductibles) that no rational individual should purchase. But the welfare consequences of behavioral anomalies in insurance are complex, because consumers’ irrational behavior takes place in a market profoundly shaped by informational asymmetries. Under some conditions, deviations from rational behavior may actually generate insurance market equilibria that produce greater welfare than would be achieved in a market in which all consumers are rational. We summarize the literature and discuss the legal and policy implications of this conclusion.
Baker, Tom and Siegelman, Peter, "Behavioral Economics and Insurance Law: The Importance of Equilibrium Analysis" (2013). Faculty Scholarship. 655.