Behavioral Finance and Life Insurance

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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.

Applied Behavioral Finance in Fundraising

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The National Multiple Sclerosis Society has learned the value of Mental Accounting over the past few years. A brilliant fundraiser arranged for a check box to be added to state income tax returns. Filers simply check the box to donate part of their anticipated tax refund to the National MS Society. Over $1,000,000 has been raised thanks to the simple check box. Benefactors are donating money that do not yet count as their own and in many cases weren’t expecting in the first place making it far easier to convince them to part with it. As of Spring 2010 Louisiana, Oklahoma, Colorado, Delaware, Missouri and Wisconsin had passed legislation to add the check box to state tax returns.

Raising money is not the only benefit of the check box. It also raises awareness about the disease.

Mental Accounting in College Funding for Couples

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‘Mental Accounting’ in College Funding for Couples

College planning can be a divisive issue for couples.

by Justin A. Reckers and Robert A. Simon

Originally Published by MorningstarAdvisor.com January 20th 2011

Last month we talked about applications for applied behavioral finance in divorce negotiations. It was a natural place to start, since financial disagreements are among the most common reasons cited by divorcing couples for splits. The fact is that we are all raised with different money lessons from our parents and communities. We develop values and learn to incorporate them into our day to day financial decision-making. Some learn how to survive on food stamps and develop self control over money because they don’t have the opportunity to spend today at the cost of tomorrow. Some never learn how to balance a check book because there will always be enough money to cover the expenditures. Once we learn these values and how to incorporate them into decisions to buy, sell, borrow, invest, and lend, they are hard to unlearn. Depression-era people can still be found with stockpiles of canned food and garages full of junk because they learned to live without these things and now can’t bear to throw them away. Young, upwardly mobile professionals let food spoil in their refrigerators because they place a higher value on earning money than spending it. So what happens when two people come together from different sides of the tracks or simply learned different values as children, adolescents and young adults? Conflict happens. Decision-making processes become family conflicts fought out over pillow talk and dinner conversations. Even worse, they become conflicts that are discussed only in one place; your office. We will talk about many sources of conflict in coming months of this column. First is college funding.

Parents make decisions every day about whether they wish to support their children financially through college. It is no cheap commitment in our current environment. This decision-making process can turn into conflict when the parental financial experiences, and values, do not match. One parent may have paid their own way through college with a full time job, night classes and student loans while the second was supported completely by parents with tuition, room and board and spending money. A generalization might lead you to think that the parent who was supported believes they should support their own children through school while the other believes children will value the experience greater if they must pay their own way. We have seen it both ways.

How each party created their money values is important to this scenario but step one to resolving the conflict has nothing to do with their money values and more to do with “mental accounting.” We often see clients planning to finance their children’s college expenses before planning to finance their own retirement. The first and most important step in planning for college funding is removing a client’s propensity to account for the money in a completely different way than their own retirement. Remind your clients they can get loans for college, but nobody will loan them money to pay country club dues in retirement. Help your client see that these pools of money are mostly fungible (meaning they cannot easily discern the difference between availability or value in each circumstance) and make sure they are paying themselves before the local university system.

You may find the root of one party’s dissent to college funding just from this conversation. Most people, given unlimited resources, would choose to pay for their child’s college education. But, if they don’t feel safe and secure that long-term planning needs (like health care) in retirement are met, they will not be able to commit to spending money in other places. Refocus the client energy on solving the long-term problems first, then come back to the values-based conversation around college funding.

It may come down to different experiences for each parent so help each of them express their concerns. We often hear parents say they think their child will try harder if they are on the hook for tuition costs. This may be true, but what if one parent believes the child should be rewarded for good performance? There are two ways we have come up with to fill the void in this decision-making process. Now we can use mental accounting to our advantage. You can fulfill each parent’s goals and values at the same time.

Start by planning to pay the bills and saving the necessary funds to do so. Don’t commit them to the end game just yet. Have the parents and child fill out and file the Federal Application For Student Aid. Maybe they will get scholarships and grants. Maybe they will be offered Stafford Loans and Parent Loans for Undergraduate Student loans. Have the parents talk with the child and let them know they want to support them financially through college, but they need the help right now and/or they want to be sure the child understands the value of hard work and remains committed (Insert whatever excuse they decide). The parents will be planning one of two things. 1) They plan to pay off all student loan debt once the child has finished their education successfully, or 2) They plan to pay off each semester’s accumulated debt at the conclusion of a semester where the child attained a certain grade point average. Either of these scenarios fulfills the parent’s needs for promoting the value of hard work and commitment through financial obligations of the student and gives the other parent security that their child will not be forced to eat ramen noodles and suffer through cold winters with no heat as a student.

These ideas won’t work for everyone as the underlying money values will be different for each couple. The key is to use your expertise to facilitate communication, craft high quality decision-making processes and use your knowledge and experience to offer creative solutions with the clients in mind.

We will continue our applied behavioral finance “couple counseling” series next month with a look at applications to decisions about life, disability and long-term care 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.

Visit the Applied Behavioral Finance blog at www.behavioralfinances.wordpress.com.

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