American Risk and Insurance Association 2006 Annual Meeting

∗ Preliminary draft, don’t quote without permission 2 The paper examines how background risk can affect the decisions of insurance, risky assets allocation and consumption rate simultaneously. Given the interdependence between background risk and asset risk, we show the agent can improve his utility if he can account for security risk, insurable and uninsurable background risk jointly in his decisions. We find that background risk and his risk attitude not only affect the ratio of risk free asset in his portfolio but also the relative holding of risky assets. One role of insurance is forming a hedging demand, thus can mitigate the impact from background risk to his portfolio. With insurance, his consumption path can be smoother. We conclude that our results can partly explain the well-known “equity premium puzzle ” as well as “asset allocation puzzle ” in the financial literature