Insurance and Portfolio Decisions: A Wealth Effect Puzzle

Abstract:
In a standard economic model, the decision to invest in risky assets and the decision to insure against the risk of loss reflect the same, albeit opposite, risk retention tradeoff. Insurance and portfolio decisions should therefore produce similar, but opposite, behavior and comparative statics. In this paper we test whether, consistent with standard theory, the wealth elasticity of demand for insurance and risky assets have opposite signs. We do so using survey data for a representative sample of U.S. households which combines comprehensive individual level information on wealth and insurance coverage. The empirical analysis produces two main results: we find strong evidence that insurance is a normal good (an important result in itself), and we identify a puzzle in the sense that, contrary to standard theory, the wealth elasticity of demand for risky assets and insurance have the same positive sign. We try to explain this puzzle using conventional and behavioral theories, but we conclude that none of these approaches are convincing at explaining the puzzle.