Applying Marginal Utility of Wealth to Insurance

Choices: A Risk-Based Economic Analysis

Introduction
In economic theory, marginal utility of wealth refers to the additional satisfaction or benefit derived
from each additional unit of wealth (Varian, 2014). Typically, marginal utility decreases as wealth
increases, meaning that the same monetary gain or loss has different values depending on an
individual’s wealth level. This concept is crucial in insurance decision-making, where individuals
must weigh the trade-off between paying certain costs today (in the form of premiums) and facing
uncertain future costs (in the form of deductibles or losses). In insurance markets, consumers often
choose between paying higher premiums for lower deductibles or lower premiums for higher
deductibles. Such decisions reflect how individuals perceive risk, uncertainty, and their own
financial capacity to absorb losses. Understanding these choices is essential for actuaries and
financial analysts because it allows them to design products that align with consumer preferences,
manage adverse selection, and improve welfare.

Theoretical Framework
Utility theory provides a framework for understanding decision-making under uncertainty.
Individuals do not simply maximize monetary wealth but instead maximize expected utility, which
incorporates subjective preferences toward risk (Mas-Colell, Whinston, & Green, 1995). According
to expected utility theory, when faced with uncertain outcomes, individuals choose the option that
maximizes the sum of possible utilities weighted by their probabilities. For example, if a person
faces a 10% chance of a $5,000 loss and a 90% chance of no loss, the expected monetary value is
-0.10 × 5,000 = -$500. However, the expected utility depends not only on the dollar amounts but on
how those losses affect the person’s overall well-being, which is shaped by their risk preferences.
Risk aversion describes the preference for certain outcomes over uncertain ones with the same
expected value. A risk-averse individual exhibits diminishing marginal utility of wealth: losing $5,000
reduces utility more than gaining $5,000 increases it. As a result, risk-averse individuals willingly
pay a risk premium (extra amount) to avoid uncertainty, making insurance attractive (Eeckhoudt,
Gollier, & Schlesinger, 2005). On the other hand, risk-neutral individuals evaluate decisions based
purely on expected value, while risk-seeking individuals prefer uncertainty when potential payoffs
are high. These differences explain why some people buy comprehensive insurance while others
prefer minimal coverage. The trade-off between high premiums with low deductibles versus low
premiums with high deductibles reflects how much consumers value reducing uncertainty. A highly
risk-averse individual prefers paying higher premiums because the reduction in financial exposure
increases their utility. Conversely, someone less risk-averse may tolerate higher deductibles to
save on premium costs, preferring to bear some risk themselves.

Application to Insurance Decisions

Consumers who opt for high premiums with low deductibles seek certainty and financial stability.
For example, a household with limited savings might prefer comprehensive health insurance with
low out-of-pocket expenses. Even though premiums are higher, the reduction in financial volatility is
worth the cost because any large unexpected expense would otherwise threaten their financial
security. From the marginal utility of wealth perspective, such households experience a steep
decline in utility from losses. The guarantee of lower deductibles prevents them from falling into
financial distress, which has a disproportionately negative effect on their welfare. In contrast,
individuals with higher income or greater liquidity may choose lower premiums with higher
deductibles. For instance, a wealthy car owner might accept a $1,000 deductible to save
significantly on annual premiums. Because their wealth cushions the impact of an unexpected
expense, the marginal utility loss from paying the deductible is relatively small. Thus, they prefer to
take on more risk and preserve liquidity. Consider two drivers: - Driver A earns $20,000 annually
and has minimal savings. A $2,000 deductible would represent 10% of annual income, creating
severe financial strain. Hence, Driver A chooses high premiums with a low deductible. - Driver B
earns $120,000 annually and has $30,000 in savings. For Driver B, a $2,000 deductible represents
less than 2% of annual income and can be easily absorbed. Driver B therefore chooses low
premiums with a high deductible. This example demonstrates how wealth, risk preferences, and
marginal utility shape insurance choices. Changes in income or wealth alter insurance decisions.
Lower-income households tend to purchase more comprehensive insurance relative to their wealth
because they cannot easily self-insure against large losses. Wealthier individuals, on the other
hand, often adopt partial insurance strategies because the utility gained from reducing small risks is
outweighed by the cost of higher premiums (Arrow, 1971).

Critical Discussion
Not all individuals facing the same insurance options make identical decisions. For example, two
households with identical incomes may choose differently due to differences in risk tolerance,
financial literacy, or psychological factors. Some people overestimate the probability of rare losses,
while others underestimate them, leading to inconsistent choices relative to expected utility
predictions. Traditional utility theory assumes rationality, but real-world decisions are often
influenced by behavioral biases: - Loss aversion: People dislike losses more than they like
equivalent gains (Kahneman & Tversky, 1979). As a result, they may over-insure against small
risks (e.g., buying extended warranties for electronics). - Liquidity concerns: Even if insurance is not
optimal in expected utility terms, consumers with limited liquidity may prefer low deductibles to
avoid cash flow problems when a loss occurs. - Probability weighting: Individuals may overweight
small probabilities of large losses, leading them to purchase more insurance than predicted by
standard models. These insights from behavioral economics explain deviations from the purely
rational predictions of marginal utility theory. Although utility theory provides a strong foundation for
analyzing insurance choices, it has limitations. It assumes individuals have stable, consistent
preferences and accurate information about probabilities, which is rarely the case in practice.
Cultural factors, marketing, and cognitive biases often drive decisions more than strict rationality.
Furthermore, utility models typically ignore emotions, heuristics, and bounded rationality, all of
which shape insurance purchasing behavior. For actuaries, this means relying solely on utility
models may lead to incomplete product designs. Instead, incorporating behavioral economics into
actuarial modeling helps capture the diversity of consumer decision-making.

Conclusion
The concept of marginal utility of wealth provides a powerful explanation of how individuals make
insurance choices between high premiums with low deductibles and low premiums with high
deductibles. Risk-averse individuals, particularly those with lower wealth, value certainty and
therefore prefer higher premiums with minimal out-of-pocket risk. In contrast, wealthier or less
risk-averse individuals often prefer lower premiums with higher deductibles, as they can absorb
potential losses without significant utility loss. However, differences in decision-making arise due to
behavioral biases, liquidity constraints, and subjective perceptions of risk. While utility theory
remains a cornerstone of insurance economics, it cannot fully explain real-world behavior without
integrating behavioral insights. For actuaries, understanding these dynamics is crucial in designing
insurance products that balance risk, affordability, and consumer welfare. By appreciating both the
theoretical and behavioral aspects of decision-making, actuarial practice can better serve diverse
consumer needs in uncertain environments.

References
Arrow, K. J. (1971). Essays in the theory of risk-bearing. Amsterdam: North-Holland.
Eeckhoudt, L., Gollier, C., & Schlesinger, H. (2005). Economic and financial decisions under risk.
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Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk.
Econometrica, 47(2), 263–291.
Mas-Colell, A., Whinston, M. D., & Green, J. R. (1995). Microeconomic theory. Oxford University
Press.
Varian, H. R. (2014). Intermediate microeconomics: A modern approach (9th ed.). New York: W. W.
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