Behavioral Finance and Life Insurance
Emotions play a significant role in life insurance decisions.
By Justin Reckers and Robert Simon
Originally Published by MorningstarAdvisor.com on February 17th 2011
There is one reason to buy most insurance products: aversion to loss. More specifically, aversion to a substantial loss. Term life insurance is what we call a pure insurance policy. If you don’t die during the term, the policy pays nothing. Unfortunately, we all die some day. The term life insurance buyer is insuring against a premature death, not death in general. Coming to grips with the possibility of premature death is not easy for some. Luckily, term life insurance is relatively cheap, so the decision to buy might be easier. As you hear on radio commercials all the time “a 40-year-old male in good health can get a $500,000 policy for $35 per month”. A whole (permanent) life insurance buyer is insuring against death in general. They know that they will die and so does the insurance company. The gamble is just how long it will take for the eventuality to be realized. Because the insurance company knows it is going to be on the hook someday, the policy is more expensive.
So let’s look at the underlying decision-making process that clients often encounter when making the decision to buy different types of life insurance, how psychology wreaks havoc upon them, and what economic theory might expect “rational” humans to do.
Life insurance has long been a cornerstone of financial plans. In some cases, when pushed by agents, it can be the entire financial plan. Life insurance products and the related sales strategies have been at the front of incorporating observations from applied behavioral finance for decades. Agents take advantage of mental accounting by pushing whole life policies as mandated savings plans. Whole life insurance accumulates cash value based on the client paying greater premiums when compared with a term policy. The difference in the premiums accumulates as cash value inside the policy. The sales pitch will say that the life insurance not only offers protection for your family in the event of the insured’s death, but it also offers a disciplined, mandatory savings plan that will help the insured stick to their retirement savings goals. The insured will then have the ability to draw funds from the mandatory savings account after a portion of every premium payment is allocated to the accumulation of cash value. This sales pitch is taking advantage of a human tendency for mental accounting. An agent will also likely inform a prospective buyer that the policy will eventually be “free,” because the cash value will have accumulated to the point at which it can pay for itself later in life. How can you turn it down? Protection for the family today in the event of death, a disciplined savings strategy that guarantees you will continue saving for retirement and “free” insurance some day. Sounds like a great deal.
So what would an economically “rational” insurance shopper do? An economically “rational” person would have no emotional attachment to the concept of “free” insurance, because we all know there is no such thing as a free lunch. An economically “rational” insurance buyer would also have no need for imposed savings discipline. They would commit to their savings goals and never depart from that commitment. Two of the three enticements to buy whole life insurance disappear along with emotional awareness. The only thing left is the need to protect the insured’s family in the event of premature death and the things that come with it. We think they would buy term and invest the difference. The economically “rational” thing to do would be to remove any emotional factors from the decision-making process. When emotional factors are removed, we can see the true purpose of insurance. The true purpose is to insure against a catastrophic loss that could have major negative effects on the financial circumstances of a family.
Why do they go ahead with each subsequent decision to write a check for a monthly or annual premium? The value for a life insurance policyholder, at the moment when a decision is made to write a check for premium, is derived not from an actual claim event, but from the peace of mind experienced by the person writing the check. The peace of mind is obtained by knowing they have provided for their family in the event of their death. That their spouse and children will not be forced to move out of a home they can no longer afford. These are visceral feelings that are hard to deny and create a framework for conceptualizing the outcome of their actions. The way a client frames an outcome in their mind affects the utility they expect. This is the concept of framing.
The visceral reaction to conceptualizing life after one’s own death keeps people writing their annual premium checks but a “rational” participant in the insurance world might second guess. The insurance company knows that the smaller number of decisions you are faced with the greater likelihood that you will make the decision they want and pay your premium. This is part of the reason why they charge additional fees for monthly or quarterly payment plans compared a single annual premium.
Life insurance is almost always a function of protecting one’s family and can be a source of disagreement among couples. Helping a couple understand the actual process of decision-making regarding life insurance with the emotions brought to the front of the conversation will help dispel 90% of disagreements on the matter. Those disagreements left over will be about the numbers–either dollar amount or duration–and these should be easy to work through given some thorough analysis.
We do not have space to debate which insurance strategy is superior, and we would certainly never say categorically that one size fits all. We believe that there are many really good uses for permanent life insurance. Everyone reading this will have their own opinion built by their experiences and preferences. We also have to pass on the opportunity to discuss the merits of Richard Thaler and Cass Sunstein’s “Libertarian Paternalism” which might encourage the types of nudges used in insurance sales tactics. We will tackle the topics of professional biases and “Libertarian Paternalism” another time.
We will continue our Applied Behavioral Finance series next month with a continued look at decisions about Insurance.
Justin A. Reckers, CFP, CDFA, AIF is director of financial planning at Pacific Wealth Management www.pacwealth.com and managing director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.
Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.