Cedric Stephens | Applying behavioural economics to insurance

The Inter-American Development Bank, in association with the Access to Insurance Initiative, published a 121-page analysis of Jamaica’s insurance industry in August 2014.

Three foreign consultants drafted the report, which had minimal impact on the industry.

The title, Improving Access to Insurance for the Low-Income Population of Jamaica, was, in one sense, understandable. The goal of the study was the construction of a microinsurance framework. A decade later, that structure is still not in place, and insurance is not more accessible than it was in 2014.

In another sense, the authors undertook an important diagnostic study of the industry to which microinsurance will be piggybacked, and that plays an important role in the economy.

Microinsurance is intended to provide insurance solutions for the low-income population. On one hand, the report’s title may be interpreted as suggesting that the middle, upper-middle, and high-income segments of the local population have fewer problems in accessing the insurance system than their low-income brethren.

On the other hand, microinsurance, by definition, implies that the existing structure that caters only for traditional products designed for members of the middle, upper-middle, and high-income groups is working effectively and efficiently.

The perceptions, attitudes, and experiences of all segments of the population about the risk-transfer industry and its products are uniformly and consistently negative. Why are our insurers not addressing the underlying problems? Why has the regulator, whose contribution to the study was specially acknowledged, not used its authority to help change the negative perceptions that many people have about insurance and the insurance industry?

This task is very important in a society that is acutely exposed to risks, especially when the State does not have the resources to function as the insurer of last resort.

Daniela Marconi and Nathalie Spencer, two behavioural scientists who work with the Insurance Australia Group, the largest general insurance company in Australia and New Zealand, recently published an article in Behavioural Economics Guide 2021, which offered ideas that help answer my two questions. The title of their piece: Using Behavioural Economics to Drive Better Outcomes in General Insurance.

Marconi and Spencer, talking about Australia, say that applied behavioural economics has made “large inroads in many industries and locations”. From my observations, this discipline is seldom used, if at all, by local industry leaders in decision-making. The ongoing controversy about the imposition of increases in fees by two leading banks is a case in point. Was behavioural economics applied in the decision-making process?

The two scientists write: “General insurance is vital for protecting consumers, communities, and businesses. But insurance is also complex, and consumers do not always get it right in terms of protecting their assets by selecting optimal coverage, renewing their policy, and taking steps to reduce the likelihood or severity of a loss event. When consumers do not get these decisions and behaviours right, it is incumbent on insurers to address this issue to prevent poor consumer and commercial outcomes.

“The insurance challenges we face today are not new, but a relatively new additional approach to addressing them is available. With its rich insight into human decision-making and its approach to behaviour change, behavioural economics provides a useful lens (among others) through which insurers can understand consumers, mitigate these challenges, and create good outcomes for all.”

Those words resonated with me. They explain why, after all the efforts that the regulator made in drafting market conduct guidelines for insurers and intermediaries, these rules have been ignored. Why? The rules presuppose that insurers and intermediaries understand and practise the principles of behavioural economics. Trying to persuade someone who is opposed to wearing a mask to prevent the spread of the coronavirus presupposes that that person understands germ theory, which posits that “certain diseases are caused by the invasion of the body by micro-organisms, organisms that are too small to be seen except through a microscope”.

According to the University of Chicago News, behavioural economics combines elements of economics and psychology to understand how and why people behave the way they do in the real world. It differs from neoclassical economics, on which insurance theory and practice are built, and which assumes that most people have well-defined preferences and make well-informed, self-interested decisions based on those preferences.

The United Kingdom’s insurance regulator, The Financial Conduct Authority, FCA, published its first paper on behavioural economics in 2013. It dealt with how “behavioural biases can lead to firms competing in ways that are not in the interests of consumers”.

The FCA chief executive said in a speech: “One of the most significant challenges for modern financial regulators and financial services alike is to recognise that we operate within a very human environment. A fallible world – not just of ratios and complex models, but also responses, sometimes flawed, that behavioural economics helps us understand.”

FCA describes five things that can make financial decisions exceedingly difficult to make well: products are inherently complex; products often involve trade-offs between the present and the future; decisions may require assessing risks and uncertainty; decisions can be emotional; and products permit little learning from past mistakes.

Making decisions about insurance involves all five things. When both parties in an insurance transaction fail to take these considerations into account pre-purchase, nasty surprises are in store for the buyer when there is a claim or many years later as buyers of universal life insurance are now discovering.

The two behavioural scientists argue that the behavioural economics approach is not about getting everyone to purchase more insurance protection. Rather, it should be used as a tool to support decision-making and understanding behaviour in a way that contributes positively to the emotional, physical, and financial well-being of individuals and society should something bad happen. They cited the results of a recent study that found that biases that affect insurance decision-making “are mostly driven by lack of knowledge or misuse of financial concepts and products and are linked to low levels of financial literacy”.

The IDB consultants provided specific recommendations addressed to the supervisory authority and the insurance industry that would contribute to developing a local microinsurance industry. The proposals were constructed on a behavioural economics foundation and can also be applied to providers of traditional insurance solutions. Implementation would benefit consumers and providers.

- Cedric E. Stephens provides independent information and advice about the management of risks and insurance. For free information or counsel, write to: aegis@flowja.com or business@gleanerjm.com