We know that people often dont maximize the expected utility of a financial decision, but rather make less than perfect decisions due to cognitive biases in decision making (often referred to as the effects of behavioral economics).
In the insurance world, a prime example of this is the person who pays a $100 higher car insurance premium to get a $500 deductible instead of a $1,000 deductible but then doesn’t turn in a $900 claim because he’s afraid his rates will go up. However, in an ideal world he should not have to worry about this, as his insurance should cover everything that it needs to cover. He also doesn’t need to spend a fortune on his car insurance, as he should be able to easily get affordable auto insurance. But maybe people think differently when it comes to the insurance world.
Another example is someone with two children and a smart phone who will spend $9 a month to cover the loss of their $400 phone, but not to provide $100,000 to help cover her income loss if she dies.
The biased reason for the first is bad mental accountingwe feel paying $100 a year is cheaper than incurring a $1,000 loss (even though the actual additional loss would be $500 and if we make it six years without a claim were money ahead). The reason for the second is vividness biaswe can see losing the cell phone, but we really dont believe well die in the next year.
Another behavior that affects decisions is treating insurance as an investment instead of a risk management tool (this ignores cases in which insurance is used as an investment). Prime examples of this are people who pay long term care or flood insurance premiums for years and then drop the insurance because they didnt get a return on their investment (enter a nursing home or be flooded). The decision to drop coverage is also influenced by projection bias, meaning that since the bad thing didnt happen in the past, we assume the odds are lower that it will happen in the future.
The fact that cognitive biases often affect insurance consumers is known; less realized is that these same biases affect other players. A book published last year written by Kunreuther, Pauly and McMorrow titled Insurance & Behavioral Economics shows that both insurers and regulators also make less than perfect decisions due to biases. As an example, in 2000 OHare Airport was insured for $750 million if the loss was due to terrorism and the premium was $125,000 a year. After 9/11 the best quote was $150 million coverage for a $6.9 million premium. Did the odds of a terrorist attack suddenly increase from 1 in 6,000 to 1 in 22? No, but the vividness of the 9/11 attack made it seem so. Even though the probability did not change, vividness bias caused pricing behavior to change.
On the regulatory/political side, hurricane coverage has driven less than ideal decisions. A prime example is in the years prior to Katrina there were thousands of Gulf Coast homeowners who refused to buy flood insurance. After Katrina we saw state officials suing insurance companies for not paying for the flood damage that the homeowners insurance policies very clearly showed was not covered, instead of passing legislation requiring people in flood plains to maintain flood insurance.
All players in the insurance game are subject to behavioral biaseswhat can be done?
One possibility is to look at all insurance as it relates to the societal cost for not having it. We require car owners to carry liability insurance (or the posting of a bond) to pay for damage the owner might cause to another, so that the person not responsible for the accident does not have to pay. Are you thinking about changing your car insurance policy? Perhaps you have just purchased a new vehicle or simply need a more affordable policy? Head to the My Car Insurance Quote website to compare a few different policies to work out your next steps.
Although car insurance is a legal requirement, depending on the vehicle you intend on driving as well as your personal circumstances, it can be expensive. However, it is often useful to know that completing additional driving courses can reduce the price of your car insurance. You can learn more about driving school courses by searching online for an online traffic school california. Why not take a look and see if you could end up making a saving on your car insurance.
Along the same lines, since hurricanes will always be with us, do you think it makes sense to require coastal homeowners to carry comprehensive hurricane and flood insurance, charge them the full actuarially fair premium, and not support them through tax dollars or subsidies from non-coastal homeowners? Do bear in mind that when a home does suffer flood or storm damage, insurance companies don’t always pay a fair amount. Many insured homeowners often find themselves needing a public adjuster Doylestown assessor to ensure that the amount they receive is fair.
On the life side, a person with dependents could be required to show assets that produce a replacement income if the person died; this would most effectively be accomplished through private insurance policies. For those of limited income, a tax credit or insurance voucher could be available. If you consider the overall cost of tax dollars paying child support costs for 1 to 18 years versus a tax credit of $200 for insurance, the tax credits are cheaper.
The message is that we need to look at the insurance marketplace in a different way. Not as one driven by liquid capital markets, premiums that are always actuarially fair and consumers who make completely rational decisions, but as an area in which many decisions are impacted by biases.
Understanding what the biases are and how they affect the purchase, regulation and management of insurance products may result in a fairer system that provides better coverage for more people at a lower cost!
