Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry (with Mark Pauly and Stacey McMorrow) Howard Kunreuther [email protected]James G. Dinan Professor of Decision Sciences & Public Policy Co-Director Risk Management and Decision Processes Center The Wharton School University of Pennsylvania Insurance Economics: New Risks, New Regulation, New Approaches SIFR Conference, Stockholm, August 24-25, 2015 0 10 20 30 40 50 60 70 80 Total numberofdeclarations Declarationsassociated with floods 1
40
Embed
Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry (with Mark Pauly and Stacey McMorrow) Howard Kunreuther [email protected].
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Insurance and Behavioral Economics:Improving Decisions in the Most Misunderstood Industry
James G. Dinan Professor of Decision Sciences & Public PolicyCo-Director Risk Management and Decision Processes Center
The Wharton School University of Pennsylvania
Insurance Economics: New Risks, New Regulation, New ApproachesSIFR Conference,
Stockholm, August 24-25, 2015
0
10
20
30
40
50
60
70
80
Total number of declarations
Declarations associated with floods
1
Some insurance markets work well• Term life insurance • Auto collision insurance • Homeowners’ insurance
But Low Probability-High Consequence (LP-HC) events puzzle consumers, insurers and politicians/regulators
• Consumers: Very limited personal experience with events• Insurers: Ambiguous risks and correlated losses pose
insurability challenges • Politicians/Regulators: Concerned with re-election and
fairness/equity
What is Great and Not-So-Great about Insurance
2
Three Motivating Examples
3
Example 1: Purchase of Disaster Insurance by Homeowners
Most homeowners in flood prone areas do not voluntarily purchase flood insurance – even when it is highly subsidized – until after they suffer damage from a disaster.
Those who do not experience losses in the next few years are likely to cancel their policy.
Similarly, demand for earthquake insurance in California increased significantly after the Northridge earthquake of 1994 – the last severe quake in the state; today relatively few homeowners have coverage.
Three Motivating Examples
4
Example 2: Insuring Against the Terrorism Risk
Prior to the terrorist attacks of September 11, 2001, actuaries and underwriters did not price the risk associated with terrorism nor did they exclude this coverage from their standard commercial policies.
This was surprising given the World Trade Center bombing in 1993, the 1995 Oklahoma City bombing and other terrorist-related events throughout the world.
Following 9/11, most insurance companies refused to offer coverage against terrorism, considering it to be an uninsurable risk.
Example 3: Insurance Regulation of Insurance
State insurance regulators sometimes have restricted insurers from setting premiums that reflect risk. Following Hurricane Andrew in 1992, the Florida insurance commission did not allow insurers to charge risk-based rates and restricted them from canceling existing homeowners’ policies.
After the severe hurricanes of 2004 and 2005 in Florida, the state-funded company, Citizens Property Insurance Corporation offered premiums in high-risk areas at subsidized rates, thus undercutting the private market.
Today, Citizens is the largest provider of residential wind coverage in Florida.
Three Motivating Examples
5
These three examples indicate that insurance today is not effectively meeting two of its most important objectives:
•Providing information to those residing in hazard prone areas
•Incentivizing those at risk to invest in loss reduction measures
Factory mutual companies in the 19th century played these roles very effectively
•Required inspections of factories prior to issuing a policy
•Poorly-monitored factories had their policies canceled
•Premiums reflected risk and were reduced for factories that instituted loss prevention measures
Key Roles of Insurance
6
How Can Insurance Encourage Loss Prevention?
7
Questions to be addressed:
•What are the decision processes that explain the actions taken by each of the interested parties based on the above three examples?
•What are two guiding principles for insurance to encourage loss prevention prior to a disaster?
•What long-term roles can the private and public sectors play if these principles are implemented?
•How can the National Flood Insurance Program be modified to serve as a model for linking insurance and mitigation?
A New Era of Catastrophes
Linking Intuitive and Deliberative Thinking for Dealing with Extreme Events
Guiding Principles for Insurance
Insurance Voucher and Mitigation Loan Program
Challenges and Questions for Discussion
8
Outline of Talk
9
WORLDWIDE EVOLUTION OF CATASTROPHES, 1980-2014
10
NORTHERN EUROPE IF GREENLAND’S ICE SHEET MELTS
A New Era of Catastrophes
Linking Intuitive and Deliberative Thinking for Dealing with Extreme Events
Guiding Principles for Insurance
Developing Long-term Strategies for Extreme Events
11
Outline of Talk
KNOWLEDGE FOR ACTIONKNOWLEDGE FOR ACTION
Linking Intuitive and Deliberative Thinking for Dealing with Extreme
Events
12
13
System 1 operates automatically and quickly with little or no effort
•Individuals use simple associations including emotional reactions
•Highlight importance of recent past experience
•Basis for systematic judgmental biases and simplified decision rules
System 2 allocates attention to effortful and intentional mental activities
•Individuals undertake trade-offs implicit in benefit-cost analysis
•Recognizes relevant interconnectedness and need for coordination
•Focuses on long-term strategies for coping with extreme events
Behavior Triggered by Intuitive (System 1) Thinking
Availability Bias – Estimating likelihood of a disaster by its salience
Threshold Models – Failure to take protective measures if perceived likelihood of disaster is below threshold level of concern
Imperfect Information – Misperceives the likelihood of event occurring and its consequences.
Myopia – Focus on short-time horizons in comparing upfront costs of protection with expected benefits from loss reduction 14
The Lowland family is considering whether to invest $1,500 in flood proofing their house so it is less susceptible to water damage.
Hydrologists have estimated that the chances of storm surge from hurricanes affecting their home is 1/100, and that if it occurs, the savings from flood proofing will be $27,500.
If premiums reflect risk their annual insurance cost will be reduced by $275 (i.e., 1/100 $27,500) if they undertake this investment.
Failure to Invest in Flood Adaptation Measures
15
Responses by the Lowland family:
• Imperfect information: Lowland family misperceives flood risk, thinking that it is 1/1000 rather than 1/100
• Threshold model: Flood risk is below their level of concern
• Myopic behavior: Failure to consider long-term benefits of flood protection
• Cancellation of flood insurance: Consider it to be a poor investment since they have not suffered any flood-related damage
Many banks do not enforce the flood insurance requirement
Many states do not enforce building codes • 1/3 of the damage from Hurricane Andrew (1992) could have been avoided if Florida
had enforced its building codes
• Today, Florida has well-enforced codes (learning from a disaster)
Illustrations of Intuitive (System 1) Thinking
16
Many homeowners cancel their flood policy if they have not experienced a flood for several years.
Reason: Flood insurance was not a good investment.
Data: Of 1,549 victims of a flood in August 1998 in northern Vermont, FEMA found 84% of residents in SFHAs did not have flood insurance. 45% were required to purchase it.
17
Lack of Interest in Protection Against Disasters:Cancellation of Flood Insurance Even When Required
New Business Year 2001 2002 2003 2004 2005 2006 2007 2008
Housing Units 841,000 876,000 1,186,000 986,000 849,000 1,299,000 974,000 894,000
1 year 73% 67% 77% 78% 76% 73% 74% 73%
2 years 49% 52% 65% 65% 63% 59% 58%
3 years 39% 44% 57% 55% 53% 48%
4 years 33% 38% 50% 48% 44%
5 years 29% 33% 44% 38%
6 years 25% 30% 33%
7 years 22% 26%
8 years 20%
Sources: Michel-Kerjan, Lemoyne de Forges and Kunreuther – Data from NFIP/FEMA
Note: our analysis of the American Community Survey reveals that the median length of residence was about 6 years over this period.
Dynamic Analysis of Flood Insurance Tenure
18
Prior to the Loma Prieta earthquake (1989) only 22.4 percent of the homes had earthquake insurance. Four years later, 36.6 percent had purchased earthquake insurance—a 72 percent increase.
One year after the Northridge earthquake of 1994 more than two-thirds of the homeowners surveyed in Cupertino County had purchased earthquake insurance.
Consumer Behavior: Purchase and Cancellation of Earthquake Insurance
19
There have been no severe earthquakes in California since Northridge and only 10 percent of those in seismic areas of the state currently have coverage.
If a severe quake hits San Francisco in the near future, the damage could be as high as $200 billion, and it is likely that most homeowners suffering damage will be financially unprotected.
Prior to 9/11, insurers did not charge anything for terrorism coverage despite the attempted bombing of the World Trade Center in 1993, the 1995 Oklahoma City bombing and terrorist attacks throughout the world.
After 9/11, most insurers refused to offer terrorism insurance, or if they did provide coverage they charged extremely high premiums.
Insurer Behavior: Terrorism Insurance
20
Responses by Insurers
• Threshold Behavior: Prior to 9/11 insurers treated the likelihood of a terrorist attack in the U.S. as below their threshold level of concern so ignored potential consequences.
• Availability Bias: After 9/11 insurers focused on enormous potential claim payments from another terrorist attack. As a result they felt terrorism was an uninsurable risk.
• Imperfect Information: Insurers failed to take into account the likelihood of a future terrorist attack when determining premiums they would have to charge for coverage, and how much firms would be willing to pay for protection.
Target of Opportunity for Insurers: 6 months after 9/11 a brokerage firm negotiated an insurance policy
where an industrial company paid $900,000 for $9 million in coverage for damage to their building next year from a terrorist attack.
Terrorism Insurance: Insurer Behavior Triggered by Intuitive Thinking
21
After the severe hurricanes of 2004 and 2005 in Florida, the state-funded company, Citizens Property Insurance Corporation provided homeowners in hurricane-prone areas with highly subsidized insurance policies. If Florida had experienced a severe hurricane in the next few years, Citizens would have been insolvent. Question: Who would bail out Citizens should such a storm had occurred?
Decision processes of politicians/regulators • Threshold Behavior: Severe hurricane is below threshold level of
concern of the public
• Myopic Behavior: Focus on short-term benefits of economic development without considering long-term consequences of a severe hurricane to the affected area and financial stability of the state
Politicians’/Regulators’ Behavior: Forming the Citizens Property Insurance Corporation in Florida
22
A New Era of Catastrophes
Linking Intuitive and Deliberative Thinking for Dealing with Extreme Events
Guiding Principles for Insurance
Developing Long-term Strategies for Extreme Events
23
Outline of Talk
Principle 1: Premiums reflecting risk Insurance premiums should be based on risk to provide individuals with accurate signals as to the nature of the hazards they face and to encourage them to engage in cost-effective mitigation measures to reduce their vulnerability.
Principle 2: Dealing with equity and affordability issuesAny special treatment given to those deserving special treatment (e.g. low-income individuals) currently residing in hazard-prone areas should come from general public funding and not through insurance premium subsidies. Funding could be obtained from several different sources (e.g. general taxpayer revenue, state government or taxing insurance policyholders) depending on the response to the question “Who should pay?”
24
Guiding Principles for Insurance
Cost of Adaptation Measure: $1,500 to flood-proof their home
Nature of Disaster:
– 1/100 chance of disaster
– Reduction in loss ($27,500)
Expected Annual Benefits: $275 (1/100 * $27,500)
Annual Discount Rate: 10%
25
Lack of Interest in Mitigation by Lowland Family with Risk-Based Premiums
Benefits over 30 years
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
1 2 3 4 5 8 10 15 20 25 30
Upfront cost of adaptation
Expected benefits over time
26
Expected Benefit-Cost Analysis of Adaptation(Annual Discount Rate 10%)
Illustrative Example: The Lowland Family Cost to flood-proof their home: $1,500
Annual payments from a 20-year $1,500 loan at 10% annual interest rate: $145
Reduction in annual insurance payment: $275
Reduction in annual payments due to adaptation: $275-$145= $130
Linking Insurance and Mitigation Via Multi-Year Loans
27
28
Everyone is a Winner
Homeowner: Lower total annual payments
Insurer: Reduction in catastrophe losses and lower reinsurance costs
Financial institution: More secure investment due to lower losses from disaster
General taxpayer: Less disaster assistance
A New Era of Catastrophes
Linking Intuitive and Deliberative Thinking for Dealing with Extreme Events
Guiding Principles for Insurance
Developing Long-term Strategies for Extreme Events
29
Outline of Talk
Long-term Strategies for Dealing with Extreme Events
30
Choice architecture •Frame the problem so that the risks are salient•Develop scenarios so people recognize the importance of insurance and investing in loss reduction measures prior to a disaster Public-private partnerships•Assist those who cannot afford to invest in protective measures•Public sector provides financial protection to private insurers against catastrophic losses Multi-year insurance •Provide premium stability to policyholders •Lower marketing costs to insurers •Reduction in the cancellation of coverage by those at risk
Choice Architecture
31
Provide better information to consumers on the role of insurance
• The best return on an insurance policy is no return at all
Use availability bias to focus on consequences to consumers
• Highlight financial problems if disaster occurred and the property were destroyed because it was unprotected and uninsured
Overcome threshold model used by insurers • Construct worst-case scenarios before a disaster• Assign likelihoods to worst-case scenarios after a disaster to show
that risk is insurable
Stretch time horizonExample: Likelihood of 100-year flood
• Next year: 1 in 100• 25 years: greater than 1 in 5 chance of experiencing at least 1
flood during this period
Encourage investment in loss reduction measures •Risk-based premiums•Home improvement mitigation loans tied to property•Premium reductions for undertaking mitigation measures
Address affordability issue •Means-tested vouchers for current residents•Covers insurance premium and mitigation loan•Condition for a voucher: You must mitigate
Public-Private Partnerships: Dealing with Affordability
32
Private sector (insurers/reinsurers) cover losses against all non-catastrophic events
Public sector (state/federal) provides reinsurance against catastrophic losses
•Insurers pay a premium upfront if there is good data to estimate likelihood of losses (e.g. natural disasters)
•Federal government pays for catastrophic losses and recoups these payments from insurers over several years (e.g. TRIA)
Well enforced building codes to reduce catastrophic losses
Encourages investment in cost-effective mitigation measures
Avoids cancellation of policies by insured
Reduces search costs to consumers
Provides budget planning to insured by having stable premiums
Reduces marketing costs of insurer
Reduces variance by spreading risk over time
Reduces insurance cycles due to catastrophic losses
Multi-Year Insurance: Positive Features
34
Regulators allowing insurers to set risk-based prices
Inability to change premiums or non-renew policies
Sufficient protection against catastrophic losses through risk transfer instruments and public sector protection
Systematic changes in risk (e.g. climate change)
Multi-Year Insurance: Challenges
35
Modifying the National Flood Insurance Program
36
Premiums would reflect risk based on updated flood maps so that private insurers would have an incentive to market coverage.
Means-tested vouchers would be provided by the public sector to those who undertook cost-effective mitigation measures.
A multi-year insurance policy tied to the property would prevent policyholders from canceling their policies if they did not suffer losses for several years
Reinsurance and risk-transfer instruments marketed by the private sector could cover a significant portion of the catastrophic losses from future floods.
Federal reinsurance would provide insurers with protection against extreme losses.
Stretch time horizon on likelihood of disasters occurring
Highlight expected benefits of loss reduction measures to key interested parties
Tie loans and insurance to the property (not to the individual) through assumable mortgage contracts or via property taxes
Examine role of multi-year insurance contracts tied to the property in encouraging investment in loss reduction measures
37
Encouraging Investment in Loss Reduction Measures
Insurance markets can help spread the risk of unavoidable disasters and offer incentives to mitigate risk. But they cannot work miracles, especially in LP-HC settings.
Insurers can encourage mitigation by being allowed by regulators to set premiums that reflect risk and partnering with banks and financial institutions to provide long-term loans. The premium reduction will be greater than the annual cost of the loan for cost-effective measures.
In this way insurers can return to their 19th century roots.
Conclusions
38
39
The Challenges of Linking Flood Insurance with Adaptation Measures
Part I: Contrasting Ideal and Real Worlds of InsuranceChapter One: Purposes of this BookChapter Two: An Introduction to Insurance in Practice and Theory Chapter Three: Anomalies and Rumors of AnomaliesChapter Four: Behavior Consistent with Benchmark Models Part II: Understanding Consumer and Insurer BehaviorChapter Five: Real World Complications Chapter Six: Why People Do or Do Not Demand Insurance Chapter Seven: Demand Anomalies Chapter Eight: Descriptive Models of Insurance Supply Chapter Nine: Anomalies on the Supply Side Part III: The Future of InsuranceChapter Ten: Design Principles for Insurance Chapter Eleven: Strategies for Dealing with Insurance-Related Anomalies Chapter Twelve: Innovations in Insurance Markets through Multi-Year ContractsChapter Thirteen: Publicly-Provided Social InsuranceChapter Fourteen: A Framework for Prescriptive Recommendations
40
Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry