Psychology and behavioural economics of insurance

Psychology and behavioural economics of insurance

For many years, softer sciences such as psychology and behavioural economics have been the ugly stepchildren of the factors taken into account in decision- making. This has changed dramatically in recent years with Daniel Kahneman (a Nobel Prize winner) and Dan Ariely revolutionising the economics world with their studies into human bias. Notable Harvard law professors have backed their studies, which has resulted in the White House and the World Bank employing behavioural economists to help them make better decisions. This has brought about policies such as Obamacare, proving that ignoring the irrationalities of the consumer would be simply irrational.

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Notable Harvard law professors have backed their studies, which has resulted in the White House and the World Bank employing behavioural economiststo help them make better decisions. This has brought about policies such as Obamacare, proving that ignoring the irrationalities of the consumer would be simply irrational.

How could an understanding of psychology and behavioural economics help us to comprehend the insurance industry? 

The reality of human nature and behaviour, often thought to be fully understood, keeps on surprising us as it is unravelled by the world’s brightest minds. Is the South African insurance industry taking full advantage of the opportunities that these revelations present?

Psychology - understanding the African market based on Maslow’s hierarchy of needs

South Africa accounted for US$49.16 billion of the US$68.97 billion of Africa’s gross written insurance premium (GWP) in 2014. This is 71.99 percent of the African insurance industry. South Africa’s gross domestic product (GDP) was US$352.8 billion in 2015. The GDP for Africa was US$2 435 billion in 2015. SA's GDP represents 14 percent of Africa’s GDP. Does it make sense that a country with 14 percent of Africa’s GDP attains 74 percent of GWP?

There are a number of factors that account for this distribution, most of which are touched on below.

Enablers for South Africa are:

  • The strength and trust in the local financial servicesindustry
  • A strong legal system necessary to enforce contractualagreements
  • Insurance is not the only means by which one candistribute or avoid risks.

Barriers other African jurisdictions face include:

  • A lack of reliable information to assess creditworthiness
  • Religious reasons such as strict adherence to Sharia law (the Islamic ban on certain types of insurance)
  • Shallow financial markets make it difficult to raise capital
  • Lack of human capital and expertise.

Other factors that may influence insurance penetration favourably or unfavourably include behavioural aspects such as:

  • The specific needs of the individuals
  • Human irrationality and loss aversion
  • The availability biasSouth Africa at 14.1 percent insurance penetration is the only country in the top 10 African countries by GDP, which is also in the top 5 by insurance penetration.

There are many factors that adversely impact the insurance market. How are these factors impacting human behaviours that drive the insurance market?

At what point does the insurance industry penetrate the market? At what income level will a person seek to obtain insurance?

Maslow’s hierarchy of needs is a basic representation of the needs of human beings. These needs start from the bottom upward and dictate human behaviour.

The need for safety and security only arises when physiological needs have been met. To estimate at what income point this is we can look at the cost of living per country. When the income per capita crosses the cost of living by a fair margin, physiological needs will have been met and inhabitants will start to strive for safety and security. One way of obtaining safety and security is by getting insurance. The preference of insurance over other means of obtaining safety and security will be determined by the reliance that can be placed on the financial services industry.

The impact of insurance might even impact needs further up the pyramid. For example, life insurance being driven by self- actualization - the legacy left behind. Regardless, insurance will only be sought once physiological needs are met. The attainment of safety and security and the profound impact on human behaviour can be clearly seen in the research done represented to the right.

In a workshop to develop an impact monitoring system, a field worker gave as an indicator “having a lock on the door”. She explained that the member had bought a lock for her houseas a result of the loan. Before the loan she had felt “less than human” - she was not a person that anyone would think of robbing. Now, although still not having anything worth stealing she felt a part of the community and could assert her identity and sense of worth by locking her house.

It is also a good illustrator of how the needs work. She met her safety and security needs through the lock. Her needs then shifted to the next level where she wanted to belong to the community.

The endowment effect

Another factor that impacts the value that can be utilised by insurers is the endowment effect. This goes hand-in- hand with loss aversion.

Simply put, people value their own possessions higher than the market does, resulting in insurance being taken out on these belongings. This can be seen in insurance marketing with insurers playing on the sentimental value of the consumer’s possessions by giving cars names or recalling memories cars might provide.

Is there potential for insurance companies to capitalise on this by providing insurance based on more than the market value of what is at risk?

Availability bias - heuristic

In another Kahneman experiment, he describes another interesting bias - the availability heuristic. The availability heuristic is a mental shortcut that relies on immediate examples that come to a given person's mind when evaluating a specific topic, concept, method or decision. 

For instance, when asked to rate the probability of a variety of causes of death, people tend to rate news- worthy events as more likely because they can more readily recall an example from memory. Moreover, unusual and vivid events like homicides, shark attacks, or lightning are more often reported in mass media than common and un-sensational causes of death like common diseases.

South African media is littered with stories of homicide and murder. The actual murder rate (as shown to the right) is very high when compared to other countries. This could cause the South African public to overestimate their odds of dying and consequently over-insuring their lives.

Do South Africans overestimate their odds of dying due to the sensational (newsworthy) ways in which people in the country are often killed?

In conclusion

Human nature - and the irrationalities that go along with it - is one of the biggest drivers of the insurance industry. The impact of this can also be seen in the marketing campaigns of insurers that play to improbable sensational fears (shark attacks, bungee jumping) to trigger the risk averse nature of consumers. To ignore human irrationality in the insurance industry would be simply irrational.

As the mystery of human nature slowly reveals itself, it creates numerous opportunities in the insurance industry. 

© 2024 KPMG Services Proprietary Limited, a South African company and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.

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