Annuity and insurance choice under habit formation

Abstract

This paper examines the impact of habit formation on the demand for life-contingent contracts in a life-cycle model. We derive an analytical solution for the optimal consumption, portfolio choice, and life insurance/annuity purchases. We illustrate the mechanism by which the consumption habit assumption can alter the bequest motive and therefore drive the demand for life-contingent products. Based on our assumed insurance/annuity markets, we show that habit formation alone leads to low demand on either life insurance or annuity but not both. However, habit formation together with social security results in low demand in both life insurance and annuity.