FLEXIBILITY, ENDOGENOUS RISK, AND THE PROTECTION PREMIUM

We introduce two types of protection premia. The unconstrained protection premium, pi(u), is the individual's willingness to pay for certain protection efficiency given flexibility to adjust optimally the investment in protection. The constrained protection premium, pi(c), measures willingness to pay for certain protection efficiency given no flexibility to adjust the investment in protection. pi(u) depends on tastes and wealth as well as protection technology whereas pi(c) depends only on technology. We show that pi(c) cannot exceed pi(u) and develop necessary conditions for pi(c) = pi(u). Optimal protection for an individual with decision flexibility may be larger or smaller than that desired under no flexibility.