Prospect Theory flipped the script on how economists think about risk. While traditional models saw people as coldly rational calculators, Kahneman and Tversky noticed something more human: we feel losses much more sharply than equivalent gains, and we judge everything relative to where we stand now, not in absolute terms.
This insight revolutionised economics by explaining all sorts of real-world behaviours that made no sense under old models. Why do investors hang onto losing stocks too long? Why do consumers respond differently to identical offers framed differently? Prospect Theory offered compelling answers.
The insurance industry provides a perfect testing ground for these ideas. Here, Prospect Theory reveals fascinating contradictions in how we approach risk. We’re simultaneously willing to pay premiums to avoid unlikely catastrophes (overweighting small probabilities) while sometimes viewing those very premiums as painful, certain losses to avoid.
Looking at insurance through this lens helps crack the stubborn “underinsurance puzzle” – why people often skimp on coverage despite clear financial benefits. When premiums feel like guaranteed losses while disasters seem comfortably remote, many choose to roll the dice.
Real-world research in developing markets shows these effects in action. A study of rainfall insurance in India found that farmers who received payouts became significantly more likely to renew their policies. The experience shifted their reference point, making future premiums feel less like losses and more like smart investments.
The reach of these psychological insights extends far beyond economics, from marketing strategies to political decisions to workplace behaviour. By recognising that humans aren’t purely rational actors but instead complex decision-makers influenced by psychological biases, Prospect Theory gave us a more nuanced and accurate picture of economic behaviour.
What makes this framework so powerful is its ability to predict precisely how and when we’ll deviate from strictly rational choices, showing that our “irrational” behaviours often follow predictable patterns tied to how our minds process risks, losses, and uncertainty.
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