Risk Preferences in Small and Large Stakes: Evidence from Insurance Contract Decisions

We examine risk preferences using the flood insurance decisions of over 100,000 households. In each contract, households make a small stakes decision, the deductible, and a large stakes one, the coverage limit. Expected utility models predict that households would choose high deductibles and low coverage limits, but households do the opposite. Allowing for probability distortions improves our models. Assessing rank dependent utility models, we find that households follow two tenants of prospect theory: overestimation of small probabilities and diminishing sensitivity to losses. In every tested model, different preferences characterize households' small and large stakes insurance decisions.