The Theory of Insurance and Gambling

This paper suggests that insurance represents a quid pro quo transaction across states of the world and is purchased because consumers desire to transfer income to a state where it is more valued. Preferences for certainty have little to do with the demand for insurance, but uncertainty itself plays a large role because it operates mechanically to make the payout a multiple of the premium. It also suggests that casino and other forms of institutional gambling represent a similar quid pro quo transaction across states of the world and that consumers gamble to transfer income to a state where it is less costly to obtain. Again, preferences for uncertainty do not motivate gambling, but uncertainty does allow for the augmentation of the payout compared to the wager. These motivations do not conflict with the empirical evidence supporting prospect theory and can accommodate the insurance-purchasing gambler. Both the demand and supply sides are included in the definitions of insurance and gambling presented herein.