Expected Utility Theory (EUT) is an economic theory that postulates how a rational person should act in an uncertain situation, and that is the rational person act when the weighted average of all the possibilities is positive and not act when they are negative. An example can help to illustrate that definition.
Let’s say someone offers to pay you $100 every time a coin lands on heads, but you owe her $50 every time it lands on tails. Should you do it? EUT says you should, and here’s why. Since the coin has an equal chance of landing on heads or tails, the expected value is $100 x .5 + (-$50) x .5 = $25. Since the expected value is positive, a rational person would accept the bet. But we know that people are not always rational.
Let’s change it a bit. You are offered a lottery ticket that has a 50-50 chance of winning $100,000 and someone offers you $40,000 for it. Would you do it? EUT says you shouldn’t as its expected value is $50,000, but unless you are very wealthy, you would probably take the 40 grand.
So that is the first chink in the EUT armor. There are more. What about casinos? The expected utility is always in the house’s favor and yet people continue to go. What about car insurance? While there may be some individuals whose claims exceed their premium, the insurance company absolutely has the positive expected utility, otherwise they would go bankrupt. And yet people continue to pay their car insurance premiums.
But what about life insurance? Well, the expected utility of term insurance is always positive to the insurance company, because term policies are actuarially designed to expire before the insured. But what about whole life?
Whole life is interesting because while the expected utility could be positive to the insured, in many cases it isn’t. The policy must be held for many years for the expected utility to be positive to the insured. And in the case of death the utility inures to the beneficiary, not the insured.
We really don’t need EUT to tell us that man is not always rational, as there are dozens of examples. And while Prospect Theory is superior to EUT in many ways and has pretty much replaced it, it doesn’t portray man’s decision making as any more rational than EUT does.
Maybe economists were wrong in the first place to assume that man is a rational being. Most of us are probably rational most of the time. But we all have quirks and idiosyncrasies. As long as they aren’t self-destructive or harmful to our loved ones, who cares? They are what make us unique. But one should never let the fact that the insurance company has the expected utility prevent oneself from procuring the required life insurance, because that would be totally irrational.