The Effect of Ambiguity on Risk Management Choices: An Experimental Study

We introduce a model of the decision between precaution and insurance under an ambiguous probability of loss and employ a novel experimental design to test its predictions. Our experimental results show that the likelihood of insurance purchase increases with ambiguous increases in the probability of loss. When insurance is unavailable, individuals invest more in precaution when the probability of loss is known than when it is ambiguous. Our results suggest that sources of ambiguity surrounding liability losses may explain the documented tendency to overinsure against liability rather than meet a standard of care through precaution. The results provide support for our theoretical predictions related to risk management decisions under alternative probabilities of loss and information conditions, and have implications for liability, environmental, and catastrophe insurance markets