Financial advice: What are the wider benefits?

In our latest article, Tim Harford, The Undercover Economist, discloses why we’re likely to over-insure small risks – and under-protect ourselves against big ones.

A risky business?

If you were a pet owner, would you think about taking out insurance to cover veterinary costs? Or how about insuring against a more costly event, such as loss of income if you fall ill? As claimed by Cirencester Friendly in its January 2019 study, UK adults are twice as likely to insure their pets as they are to insure themselves.

We might surmise that animal-loving Brits don’t want to come across as heartless regarding the health of their furry friends, or that studies authorised by income protection plan providers will emphasise the need for…income protection.

The most palpable deduction – backed up by other research – is that many people have a tendency to think irrationally about risk. We’re prone to over-insuring small risks – such as the unexpected vet bill or the holiday hire-car excess – and under-protecting ourselves against bigger risks – for example, becoming too ill to work or running out of funds in old age.

We’re only human, after all

Behavioural economics can give us some clues. One motive behind small-risk insurance is ambiguity aversion – an idea teased out by economist Daniel Ellsberg.

Ellsberg told his experimental subjects that there were two pots – the first containing 50 red balls and 50 black balls. The second had 100 balls; each was either red or black, but they weren’t told the proportion. Next, they were asked to draw a red ball for a cash reward. Which pot would you draw from?

Rationally, the second pot is just as likely to give a better or worse chance than the first pot. However, the majority of people select the first, as humans prefer the known quantity. Similarly, this way of thinking might go some way to explaining why we prefer: “Getting a dog will cost £120 a month including pet insurance” as opposed to: “Getting a dog will cost £90 a month plus unpredictable vet bills”.

Nobel Prize-winner Daniel Kahneman and his long-time collaborator, Amos Tversky, offer another piece of the jigsaw – that of loss aversion. Essentially, loss aversion is anxiety about risks – even small risks – that are judged as losses rather than gains.

Indeed, it’s often wise to be vigilant, yet the modern world is full of bad deals designed to feed this anxiety. For example, at the car-hire desk, you’re told the excess is €1,250 – do you want to waive the excess for just €15/day? This may be tempting, even if you have a hunch that €15/day grossly overstates your risk of having a crash.

You’d be right: third-party excess insurance costs just a fraction of the price. Many small-risk insurance offers are ridiculously poor value. Logically, we should reject them all, instead saving for contingencies. After all, most of the time, a cracked phone screen will be more than covered by the healthy dog and the unpranged hire car.

Such losses are insignificant compared to the ‘real’ risks we come across, such as divorce, illness, redundancy or disability. One broad guideline is that if you can afford the loss, maybe you shouldn’t buy the insurance – and if you can’t, the insurance may well be worth the price.

Difficult questions

Yet our hesitancy to grapple with more sober scenarios is trickier to explain. One option is a basic failure of probabilistic thinking – Tversky quipped that people assign risks to one of three categories – ‘gonna happen’, ‘not gonna happen’ and ‘maybe’. Are we just too quick to move grave dangers to the ‘not gonna happen’ category?

“Do I need critical illness cover?” might turn into the useless: “Do I feel reasonably healthy today?” Big risks are generally long term, which raises the ‘future self’ problem. The person who might prang the holiday hire car? Definitely me. However, the person who might one day be crippled by depression? Not sure that poor soul could possibly be me.

Psychologist Hal Hershfield looks at ways to overcome this problem, such as holding imaginary conversations with our future self. In fact, when Hershfield asked experimental subjects to interact with a computer-generated representation of themselves in old age, they showed more interest in saving.

A simple stimulus?

Nevertheless, tackling life insurance and pensions is the kind of worthwhile-but-unpleasant task we always plan to deal with, yet somehow manage to put off.

This process of procrastination is known as ‘hyperbolic discounting’, and it’s cleverly exemplified by a study of movie-watching. Daniel Read, George Loewenstein and Shobana Kalyanaraman got their subjects to choose a movie to watch the following day. Most opted for something in the realm of high-brow self-improvement, such as Schindler’s List. However, when the day came, the researchers offered ‘Groundhog Day’ – and the subjects were only too pleased to watch some simple fun instead.

With small-risk insurance, we’re forced to make decisions. But considering retirement plans or big-risk insurance cover is often a ‘Schindler’s List’ that we believe we can delay forever.

Behavioural economists have suggested various ways that institutions might apply this insight to prompt people to engage in saving and pensions, but psychologist Dan Ariely and colleagues discovered a simple technique that anyone can use – subjects in Kenya saved more when he asked them to keep a gold-coloured coin on prominent display at home as a daily reminder.

Maybe we could all benefit from something like Ariely’s coin – similar to a memento mori, but to remind us of life’s ups and downs rather than its inescapable end. Something that we’ll look at on a daily basis that will urge us to ask ourselves if we’ve seriously considered insurance recently. Might a pet do the trick?

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