MyPath Q&A With “Insurance & Behavioral Economics” Authors Howard Kunreuther and Mark Pauly

Book cover: Insurance & Behavioral Economics: Improving Decisions in the Most Misunderstood Industry, by Howard C. Kunreuther, Mark V. Pauly, and Stacey McMorrow

In the book “Insurance & Behavioral Economics: Improving Decisions in the Most Misunderstood Industry,” authors Howard Kunreuther, Mark Pauly and Stacy McMorrow dig into why customers, regulators and even insurance company executives often have such a skewed perspective of insurance. Kunreuther and Pauly, both professors at The Wharton School at the University of Pennsylvania, spoke with MyPath about their research and how they want to change society’s perception of insurance.

MyPath: How would you summarize the key arguments in the book?

Howard Kunreuther: The reason we wrote this book is that we saw ways insurance could provide decision makers with guidelines as to when they should protect themselves prior to a disaster rather than waiting until after the event occurs. We also have some suggestions as to how to assist people in understanding insurance concepts more intuitively. The inability to understand insurance is why the book’s subtitle calls it “the most misunderstood industry.”

Mark Pauly: The other point we wanted to make is that there is considerable variation across different kinds of insurance in terms of whether people behave in ways consistent with an economic model of rational behavior. In those markets where some forms of insurance don’t function well, we were interested in public policy and whether anything could be done to improve how they function.

MyPath: How would you explain insurance better so that people understand what they’re buying?

Howard: I think one of the biggest challenges is that people have a hard time understanding that after insurance is purchased, one should still recognize that the best return is no return at all. People should celebrate not having a loss. Maybe insurers should give them money for a dinner or some way to celebrate not having a loss!

Mark: I think that insurers could do a better job communicating the nature of their business. One simple way to do that would be to make apparent to the insurance buyer how much has been paid on this policy in the past relative to the premium. It won’t be 100 percent because the company has to make some money, but the payment rate should be pretty high. By publicizing the amount that’s returned to buyers of insurance, I think we can change attitudes a little bit.

My second point is that politicians are often all too eager to bash insurers when someone might have thought or wanted to think that their coverage was more extensive than it really was. Of course nobody sympathizes with “gotcha” clauses and excessive fine print in policies, but sometimes people pretend that they thought insurance would pay for something and then complain. There’s always an audience for those complaints, in part because of this view that insurers have an inexhaustible supply of money.

Howard: One of the points we raise in the book is that the insurance industry is considered offering an all-hazards homeowners policy. People would feel more comfortable knowing that they are protected against a spectrum of potential disasters rather than having to purchase separate policies for certain hazards, as they have to do today for earthquake and flood coverage. It would also avoid a lot of the controversy that always comes up after a hurricane, when it is hard to determine whether the damage was caused by wind or water

MyPath: Would explaining insurance better also help people make better decisions?

Mark: It’s human nature to ignore things that haven’t happened for a long while or assure yourself that “it will never happen to me.” But we do think that improvement can be made in terms of getting around at least some of these anomalous behaviors on the part of consumers.

Howard: Insurers have to recognize the systematic biases with respect to low-probability events. We have a number of suggestions on how these biases could be addressed to encourage those at risk to buy insurance and invest in protective measures to reduce their losses from the next disaster.

MyPath: What fascinated us about the book is that behavioral economics shows how bad many people are about thinking about the future, and yet almost everyone has some form of insurance to prepare for the future. Is insurance something that should get a little more respect than it does?

Howard: Absolutely. But we do find ourselves asking the question, “What insurance would be bought if it wasn’t required?” There is coverage that many individuals buy voluntarily, like life insurance. Other interested parties, like banks and financial institutions, make sure that their investments are protected and require insurance as a condition for a mortgage. And states typically require auto insurance when cars are registered.

Mark: In many cases, it’s possible to make insurance kind of the default option. Believe it or not, not everybody is like us and thinks about insurance first thing in the morning. They think about other things, and insurance becomes easy to ignore. Making it a no-brainer may be a good strategy.

Howard: Let me pose a question to your readers: Do you think that we could ever get people to talk about insurance at cocktail parties or get society to understand the importance of insurance in encouraging investments in protective measures prior to the next disaster?

MyPath: It is kind of amazing that insurance exists despite all the biases that come from the way our brain is wired. Maybe it’s not possible on a large scale to make insurance happen without requiring it, but we do think that there may be some ways to get people to at least appreciate the idea of working together, pooling your resources and supporting the less fortunate of us, even if we know that the money might not go to us.

Mark: We do speculate in the book that in some circumstances, mutual insurance may be easier for people to support than stockholder-owned insurance companies because it feels more like people are really keeping money to themselves. Of course, a well-functioning insurance company with low prices for high-value coverage is going to succeed no matter how it’s organized, and that’s the best of all possible things. But emphasizing the mutual nature of insurance can sometimes be a good thing to do.

For more information on how insurance works, visit our How Does Insurance Work? page. To find other interesting ideas from Wharton’s Risk Management and Decision Processes Center, visit its website.