Pricing Insurance and Warranties: Ambiguity and Correlated Risks

This paper reports on the results of a questionnaire study of pricing decisions made by professional actuaries when the probabilities of a loss are either ambiguous or nonambiguous. Theoretical hypotheses derived from the expected utility model were compared with the implications of procedures described by practicing actuaries. Actuaries were asked to act as consultants to a computer manufacturer concerning the price of a warranty. The suggested prices were considerably higher when probabilities were ambiguous than when they were well-specified. These pricing decisions were consistent with the procedures described by actuaries but inconsistent with predictions from expected utility theory when the risks are perfectly correlated. Further insight into the actual decision process is provided by interviews with actuaries and an analysis of comments written on the questionnaire forms.

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