This is first of our three Behavioural Economics (BE) blogs. In this blog we shall explore what it is and why it’s important in insurance.
Since the FSA split into the PRA and FCA, the idea of Behavioural Economics (BE) has taken a strong foothold at the Financial Conduct Authority (FCA) and that’s good enough for me. So what is it? Essentially it’s the study of how psychological undercurrents (biases) distort how we ‘see’ the world. Often these biases lead us consumers into making poor decisions; at least compared to what traditional economic theory says we should do.
You may be wondering why this is a particular issue for the FCA. Certainly, I can think of many other situations where these in-built biases influence our choices. For example buying a designer t-shirt for £30, when we can get one of similar quality from Primark for £3. It’s because the sums involved in financial products can be large, the products complex and often there are information asymmetries putting the buyer at a further disadvantage. These are the core reasons why the FCA has been given the responsibility to protect consumers, whereas there’s no one telling us that we can’t spend £30 on a t-shirt.
Theory and practice
Traditional economic theory is founded on the assumption that we consumers make rational choices. To do this we need to understand what we’re looking at. Then we must assimilate all the information, think carefully and come to a logical (and impartial) conclusion. In other words it assumes knowledge, comprehension and conscious effort. That doesn’t sound like many people I know! In fact I have to admit I recently renewed my home insurance. Having done so I realised I should have moved a year earlier, having just taken £300 off the cost for near-identical cover.
In his book ‘Thinking fast and slow’ Daniel Kahnenman, one of the main proponents of BE, suggests we only think slowly and carefully some of the time. He puts forward the idea that there are two modes of thought – intuitive (fast) and reasoned (slow); moreover we often use the former without realising it, to our detriment. What’s more many of these ‘mistakes’ are predictable, using the science behind BE.
This is where the FCA comes in. Their aim is to promote effective competition based on price and quality. In effect this means they are there to protect consumers where there is evidence the market isn’t doing this of its own accord. They are now using BE to identify so called biases, for example framing. They then try to understand what’s driving them and design solutions to protect consumers. They are particularly interested in products where these biases are amplified by firms or entire markets for unfair profit.
It’s worth noting that where biases are amplified by individual firms or markets, it may not be something that is deliberate. The problem is that financial products are complex, they require consumers to make decisions about risk and trade-offs, which are all difficult when you’re not doing this on a regular basis. The problem is exaggerated because the UK has a capitalist economy (like most other countries) as such firms and individuals are motivated to maximise profit. It is this feature – which drives efficiency, progress and competition – that is also its Achilles heel. This is exactly why we need the FCA and why they are using new techniques like BE to protect consumers.
Types of bias
As the FCA note in their paper there a numerous separately identified biases, which have been recorded in scientific literature on the subject. Clearly not all are at play in any particular situation and where they are their impact will vary according to the circumstances. That said there are a number of biases that are known to have a more significant impact in financial decision making. The FCA categorise these into three groups:
- Preferences – present bias; reference dependence/loss aversion; and regret
- Beliefs – overconfidence; over-extrapolation; and projection bias
- Decision-making – framing; mental accounting/narrow framing; rules of thumb; and persuasion/social influence
Preferences – what we want – are where decisions are unduly influenced by emotions? For example, according to reference dependence/loss aversion people feel the ‘pain’ of loss twice as much as they feel the ‘joy’ of gains. It is very easy to frame insurance to stress how much a policy could save the consumer from losing, particularly if the premium is compared to a much higher reference point. Extended warranty is a good example of where the value of the policy is often low but the price seems cheap relative to how much the consumer has just spent on their new MacBook Air.
Beliefs – what we (mistakenly) believe – are opinions about a situation that we place too much faith in. Over-extrapolation is a classic case in point. If you’d bought Tesla shares at the start of 2013 by late September you’d have been telling your friends how the shares had gone up nearly five times, over three quarters. Sadly, for your friends, if they had gone out and bought them assuming this growth would continue, they would have been severely disappointed. They lost a quarter of their value in the last three months of the year.
Decision-making – (over)simplifying the problem – is about how we simplify a particular situation in order to make the decision-making process simpler. Rules of thumb are commonly used by people, often unconsciously. The ‘snowball method’ of debt management suggests there are psychological benefits from paying off the smallest debt first – you don’t just see the monetary amount reduce but the number of debts too. This is in stark contrast to simple maths that will tell you to pay off the debt with the highest interest rate first. Indeed it’s quite possible that the additional interest on high-rate credit cards could outweigh the capital repayment on a low rate loan.
In the next blog – Three is the magic number – I’ll look at how the FCA is using Behavioural Economics in its regulation of insurers and markets.