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Whys and Hows of insurance: A behavioral perspective

How do we buy insurance? Which factors have the most impact on our final decision? Is it price, advertisement, or rather previous life experiences that affects our decision the most? In this week's blog, we will delineate the answers to these questions through the lens of behavioral economics. In doing so, we will provide actionable insights that can aid insurance industry practitioners to better position their value proposition. 


We have already explained that the standard economic implications do not hold within the insurance industry. People are widely influenced by behavioral biases while making their purchase decisions, and under some circumstances, in stark contrast to the expectation, price has a minimal impact on consumers’ purchase decision. However, prior to expounding on the hows of insurance, we will first look into the whys of it.


Why do we actually buy insurance? The Fourfold Pattern of Risk Attitude


We have talked about differences in perception of losses and gains, whereby an equivalent amount of loss is perceived to be much greater than an equivalent amount of gain. We have also talked about how we misjudge probabilities, as such, we overweight and underweight the occurrences of low and high probability events, respectively. Combining these two brings us to the below depicted fourfold pattern of risk attitude.



As the figure illustrates, the overweighting of low probability events, in combination with the inherent risk aversion we have against large amounts of losses, creates an innate, psychological need to be insured, which is referred to as insurance motive in the literature. If you have ever found yourself contemplating whether to buy insurance against alien abduction (Florida UFO Abduction Insurance Co. offers one), we guarantee you that it is this insurance motive that caused it. 


Within the insurance parlance, even though the actuarially fair value remains constant, this insurance motive will translate into purchase behavior, since the subjective probability that people base their decisions on will be higher than the objective probability of the event that the insurance is priced with. Similarly, as people overweight losses, a discrepancy will arise between their objective and subjective values. Subsequently, keeping the amount of losses constant, this difference in the subjective and objective probabilities will translate into consumers valuing insurance more than it is actually worth, thereby increasing the demand for it.


How do we buy insurance?


Anchoring


One of the key points in choosing an insurance option (and consumption choice in general) comes from information asymmetry. As mentioned in last week’s blog, should insurance companies provide information, trust towards them will increase, which is key for a service that is in practice a “credence good”. However, due to the nature of insurance, this could only be achieved partially: pricing in insurance is (mostly) based on econometric calculations, which in itself is abstract enough to make prices hard to understand. As such, when evaluating their options, people can mainly rely on “intrinsic values”, and would have to make comparisons to evaluate their prospects.


As a result, comparisons in general are highly important, especially in cases where the product or service is abstract. We could compare two main things in the case of insurance: first, the price of what we want to insure, and second, the prices given to us by insurers. If we were to insure our house, using the intrinsic evaluation, we have an approximation of the value of the house: based on that, we could deem a 300€ monthly insurance fee to be fair or not. The choice becomes much less clear when dealing with life-insurance, as we are suddenly charged with the question: “how much does our life worth?”. As the price becomes more abstract, we turn to comparisons and try to find our value-option.


Previously, we talked about the importance of anchoring bias in decision-making (see post here). In short: when we have limited information on something, we tend to compare our options to the first information we were given. If someone were to tell you that they pay a monthly fee of 100€ for their life-insurance, you would start to look for offers around that price. Or if someone told you that the risk of being bitten by a shark is greater than that of crashing with an airplane – you might change your mind, and insure yourself against injuries from wild animals. Similarly, if your house was robbed recently, and you’re afraid that it might happen again, you insure yourself against it – if your fear of it happening again outweighs the Monte Carlo fallacy (“what are the chances that it will occur to me again?). 


The previous examples demonstrate three ways how your perception could be “anchored” to services: the first one emphasizes the price or the value of the service, while the second one does the same but from a risk-perspective. The third one relies on the previously mentioned “recency effect”, that is: we tend to overestimate the probability of the occurrence of rare events that happened recently. As such, in the following months, we might see an increase in insurance-options and a rise in demand for insurance against global epidemics.


Mental Accounting


Mental accounting concerns the process by which people ‘mentally’ group their funds based on its intended use or source. In other words, mental accounting is the primary reason that we have different budgets for grocery shopping, utilities, travel, and eating out. Furthermore, the willingness to spend for each account depends on its categorization. A mental cost arises when people use another accounts’ funds for a different activity. A good example of this phenomenon is the reluctance of people to spend funds from their savings accounts. 


Regarding the insurance industry, evidence suggests that allocated funds for insurance arise from the mental account that is labeled as “expenditure on protective activities”, which is already committed to spending considerable funds on the other activities, rather than insurance. This emphasizes that the mental account to which insurance belongs is already being exhausted, which further leads into people saying ‘I cannot afford to buy insurance’. Accordingly, when people buy insurance they consider whether they have available funds in their protective activities mental account. However, the lack of remaining mental funds allocated to insurance creates a demand problem for insurance practitioners that needs to be addressed. This can be overcome through repositioning the insurance in the minds of customers, as such, the spending on the mental account of insurance will be shifted to another, relatable account that has available funds to be spent. 


The value of underlying asset and regret aversion


Why do you insure your house and car, rather than insuring your watch? Given that the insurance is fairly priced, on a purely mathematical basis, if the price of insurance equals its fair value, people should be indifferent between insuring different types of assets. However, in reality, the insurance of some assets is of course more important from the perspective of maintaining financial security, since people’s financial resources are limited. For example, almost no one chooses to insure items with really small monetary amounts. This occurrence is due to the presence of regret aversion, which is concerned with the observed tendency of people to make decisions based on how they would feel about the occurrence of a loss, and the resulting level of regret. Accordingly, as small items are replaceable, the associated regret levels are lower and therefore leads people to not purchase insurance for these items. Similarly, people’s tendency to purchase insurance against hard-to-replace items, as dictated by their monetary value, is higher. These emphasize that replaceability, by dint of affecting the regret associated with loss, is another significant factor having an impact on the purchase and choice of insurance. 



References and Further Readings


Lee, P. C., Chertow, M. G. and Zenios, S. (2009). An Empiric Estimate of the Value of Life. Value in Health, 12(1), pp. 80-87.


Braun, M. and Muermann, A. (2004). The Impact of Regret on the Demand for Insurance. The Journal of Risk and Insurance, 71(4), pp. 737-767.


Thaler, H. R. (1999). Mental Accounting Matters. Journal of Behavioral Decision Making, 12(1), pp. 183-206.


Scholten, M. and Read, D. (2014). Prospect theory and the “forgotten” fourfold pattern of risk preferences. Journal of Risk and Uncertainty, 48(1), pp. 67-83.

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