Representativeness and managing catastrophe risk

Abstract

The representative heuristic causes individuals to underweight prior probabilities and overweight posterior probabilities. We examine the effect of the representative heuristic on the demand for insurance and participation in mitigation activities. Pre-disaster, the representative heuristic leads to lower demand for insurance, even for a subsidized policy; indeed zero coverage may be optimal for a subsidized policy. After a disaster occurs, the heuristic causes individuals to demand more insurance than those not subject to the heuristic, even if policies are unfairly priced. We depict the subsidization needed prior to a disaster to induce individuals to purchase insurance and show the level of unfair pricing that can be tolerated post-disaster. Similarly, the heuristic causes individuals to have a lower willingness to pay for mitigation activities pre-disaster, relative to an individual not subject to the heuristic. Post-disaster the heuristic causes willingness to pay for mitigation to be higher.