Financing State-Dependent Indivisible Expenses With Insurance

Abstract

Standard economic theory interprets insurance as a means for risk-averse individuals to transfer risk. I argue that another important function of insurance is to optimally finance indivisible expenses that only have value in particular states of nature. Contrary to traditional predictions, insurance is then a normal good, the additional consumption of the covered goods and services by the insured is not a sign of inefficiency, and the marginal-utility gap between states is not informative about the value of insurance. Acknowledging this additional purpose of insurance requires a novel understanding of risk attitudes in general, and a reconsideration and possibly reevaluation of previous policy advice.