Behavioural finance and the insurance industry

Insurance Connect | October 2020

Italians are frequently mocked for their poor financial education. Admittedly, the data are unforgiving: 795 billion euros are currently deposited in non-interest-bearing accounts, less than one Italian out of ten has home insurance, and we could add hundreds of other examples. 

Part of the blame must lie with supply. The insurance market, just like the market of investment products, is driven by supply, which seems to have finally awoken from a long and deep slumber. 

The awakening of the supply was quite abrupt, caused as it was by a drop of interest rates and the consequent reduction of bank margins. As a result, banks and financial networks were compelled to look for new sources of income in the insurance market, a field with an enormous growth potential. However, yet another wakeup call came from the pandemic.  

On that note, it is crucial that insurance companies, agents, banks and financial advisors thoroughly understand the mental mechanisms that are considered to regulate individual behaviour. And to this end, agents and insurance companies may avail of the principles of behavioural finance, a subject that has been successfully applied to the field of financial consultancy for some time.

Indeed, behavioural finance effectively combines studies on Economics, Finance and Psychology. One of the forefathers of behavioural finance is the economist and philosopher Adam Smith, born in eighteenth-century Scotland. However, it was not until the last few decades that the field of behavioural finance could truly grow and gain scientific recognition – we need only think of the 2017 Nobel Prize in Economic Science awarded to Richard Thaler for his contributions to behavioural economics.

The aim of behavioural finance is to understand the behaviour of financial markets in connection to the patterns of behaviour of both society and individuals, proceeding from the assumption that people are not completely rational, and markets are not always efficient. 

The principles of behavioural finance can be summarized in five key points: 1) some emotions (greed, fear, uncertainty) affect people’s choices causing irrational behaviour; 2) choices are influenced by both who offers solutions and how solutions are offered; 3) all people are subject to cognitive bias – while our mind works rationally, it can be misled by the delusion of being able to dominate uncontrollable phenomena; 4) people’s loss aversion is such that a loss matters 2,5 times more than a gain of equal value; 5) markets can behave irrationally and inefficiently due to anomalies and miscalculations. 

The same principles may be applied to the field of insurance:

1) inhibited by the sense of uncertainty about the future, people are inclined to keep their money under their pillow instead of protecting from risks;

2) proactivity and a good ability to communicate are crucial characteristics in companies and agents;

3) as for cognitive biases, many people feel that accidents happen only to others;

4) the subscription of an insurance policy is seen as a “loss” instead of an investment;

5) with regard to market inefficiency, we need only think of the Covid-19 pandemic and how it caught us all unaware. 

However, before insurance companies, agents, banks and financial networks can move in this direction, some issues need to be addressed. The first is the ability of a good insurer to anticipate the client’s unspoken needs, acting as a maieuta and working on risk awareness. 

The second issue is connected to the intangibility of the insurance service. In fact, coupon products – T-Bills, or the more recent income funds – are quite successful as they emphasise current income. In the insurance field, the degree of continuity and tangibility of the benefits of an insurance policy tends to be higher when the risk is more recurrent (for instance, the fields of medical diagnostic, climatic events, or breakdown assistance). Insurance coverage needs to be adequate, while insurance companies need both commercial and actuarial skills. 

The third issue has to do with planning. Indeed, every individual or family have projects; the ability to identify them and to contribute to their realization while protecting them from adverse natural phenomena (temporary job loss, a falling tree etc.) makes the difference between the good and the bad insurer.

The last issue concerns clarity and simplicity in communication. The good faith and transparency of both the insurer and the insured is crucial to a process which requires the client’s listening skills and ends with the proposal of a solution and its acceptance. 

As in any success story, the difference between those who will disappear from the insurance market and those who will keep growing depends on their ability to adopt a win-win logic in which there are no counterparties, only partners. 

Nicola Ronchetti

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