‘Standard economics assumes that we are rational… But, as the results presented in this book (and others) show, we are far less rational in our decision making… Our irrational behaviors are neither random nor senseless- they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains.’
Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions (2007)
Traditional economics assumes that we are rational, utility-maximising agents that consume by reason of self-interest. Whereas in reality, our decisions are not always practical and may be influenced by social or psychological factors that cause us to make choices that were otherwise unusual or groundless and may contradict the economic models we are taught in standard economics. As a result, by the late 1970s, the idea that human behaviour was not completely rational and was vulnerable to biases was popularised and became integrated into the economic thinking of today (Thaler & Ganser, 2015). ‘The behavioural revolution (in economics) imported ideas from behavioural psychology into finance, and replaced the rationality postulate with a more realistic alternative.’ (Shefrin, H., 2015) Hence, behavioural economics is the study of the human behaviour and the influencers that affect our choices, and is bridge between economics and psychology. By identifying common behaviours and habits, this area of study helps economists to better predict decision-making processes of the people.
This particularly applies to the healthcare industry as healthcare is not the “usual” good like food or clothes. For most commercial goods, reducing consumption leads to some lower quality of life or satisfaction, whereas for healthcare, reducing consumption may lead to worse health and even death (Low, D., 2012). Due to the presence of imperfect information, patients (the Principal) also largely rely on their doctors (the agent) to administer the medication, giving the healthcare firms the power to control the demand of medication and even administer more medication than needed, leading to the issue known as “supplier-induced demand” (Low, D., 2012).
Factoring in the irrationality of consumers in decision-making, the healthcare market is difficult to predict or direct. For instance, we are often reminded to care for our health in order to live a more comfortable and longer life. So the rational course of action would be to eat less junk food and more fresh fruit and vegetables, and even go jogging in the morning. Yet, many human inventions, such as the lift and escalator, cater to the human lethargy and rarely do we find time to actively exercise amidst our sedentary lifestyle in Singapore. Traditional economics assumes that we would calculate the effective cost and consequences regarding the maintenance of our health in the future, opting for the choice with the least opportunity loss but in reality, almost no one goes through this tedious cost-benefit analyses before committing to a decision (Low, D., 2012). Therefore, illogical behaviour leads to consumers straying from the ideal of an “economic consumer” and behavioural economics is needed to anticipate these abnormalities and create more accurate predictions of the consumer market.
So what is (private) insurance?
I believe that the concept of insurance is not foreign to most, but I will be giving a more in depth description of the insurance industry to set the context of this essay. By definition, insurance is a ‘technology of risk’ and ‘the practice of a type of rationality potentially capable of transforming the life of individuals and of that population’ (Ewold, F., 1991). This means that insurance breaks down and organises the possible risks in reality in an exact and calculative manner and through this tedious calculation, insurers are able to objectivise events and transpose impediments into possibilities (Ewold, F., 1991). Imperfect information also exists within this market as consumers very limited personal experience with these high-risk events while insurers are posed with ‘ambiguous risks and correlated losses pose insurability challenges’ (Kunreuther, H. C., et al., 2013). Ultimately, risk is a fundamental aspect of the purchase of insurance, where insurance comes with risk that softens the blow of anticipated unfortunate events that may happen based on an individual’s background or status.
Private health insurance are bought by individuals through the payment of premiums, where the premium rate of health insurance varies based on factors such as health conditions, age, possible inherited traits and environment. Insurance companies meticulously factor in these conditions to adapt an insurance contract specific to the individual in order to productively improve the consumer’s welfare. The objective of private health insurance is to ‘allow (consumers) to enjoy protection against risks of large bills without any of (them) having to save fully for them’ (Low, D., 2012).
There exists unequal spending on healthcare that varies with each individual as not everyone suffers from expensive treatments from illnesses like cancer or tragic accidents (Volpp K. G., et al., 2011). Insurance may indirectly help to redistribute the financial burden of the unfortunate individuals onto other consumers within the firm, making health treatment more affordable for them. This highlights the improvement of overall societal welfare when insurance is allocated and used fairly and effectively (Cremer & Roeder, 2017). However, this may not always be the case as the unequal cost of premiums may also lead to situations where those who truly need insurance are unable to pay for the high cost. Such an example would be that of the elderly where some firms may refuse coverage based on their age or health status, and even when offered, many of these elderly are unable to afford the coverage (Fang, Z., 2012). This results in loss in societal welfare and there is inequity when the insurance firm does not provide universal coverage for the society.
Behavioral economics in the market for insurance
Insurance and human behaviour, and thereby behavioural economics, are closely related as the transaction between the individual and the firm is based on human interaction and the transfer of private information (多尔夫曼, 1998). Many of us have reservations or biases towards the idea of insurance. Nonetheless, behavioural economists, Wright and Ginsburg suggest that the behaviour of consumers can be predicted and regulated by adjusting the way choices are framed for them, increasing their welfare based on their preferences (Wright, J. D., & Ginsburg, D. H., 2012). Behavioural economics aids in identifying these biases towards insurance, allowing insurers to better understand their audience and perform accordingly.
One of the most common biases would be overconfidence. Overconfidence is a bias that arises from misperceptions of probability distributions i.e. risk misperceptions (Astebro, T., et al., 2014), where consumers overestimate their extent of knowledge, underestimate risk and overstate their control over events (Wassenaar, J., 2016). This would be the case where the individual believes that there is no need to be insured due to their belief in their ability to stay healthy and safe, that insurance would be an unnecessary investment. An able-bodied young man, for instance, may not see the need to buy health insurance as they believe that they live in a safe environment, abide by the road safety rules and do not engage in violent activities. However, they may become involved in an accident, simply by the act of using his mobile phone while walking. Life is often unpredictable, even when we believe we are in control of our fate. Yet, this bias may also be seen as a strategy to obtain a cheaper premium rate. Therefore, insurers attempt to identify this bias by detailed monitoring of the consumer, reviewing if the consumer is overestimating himself before creating the contract (Wassenaar, J., 2016).
Another cognitive bias would be the anchoring bias, where people make estimations ‘skewed by irrelevant information that we happened to see, hear, or think about a moment ago’ (Tversky & Kahneman, 1974; Lieder, et al,. 2018). In layman terms, anchoring is the bias in which we are affected by preconceived thoughts or information subconsciously, causing our final decisions to deviate towards that piece of information. An example would be the estimation of premium rate by a consumer, based on their knowledge of the cost of insurance for a minor injury. This may cause them to imagine a higher than actual premium rate of a major injury. Zur Shapira and Itzhak Venezia also highlight that ‘self-generated anchors help simplify the complex cognitive process involved in making judgments’ (Shapira & Venezia, 2008), explaining that this bias occurs due to the person’s need to shorten thought processes and building on their prior knowledge. Hence, anchoring bias is also one that insurers look out for and attempt to debunk if any incorrect assumptions are created or exist.
Lastly, as of this essay, inertia is a bias in which is a persistent preference towards an original decision, despite the presence of new information, due to loss aversion and fear of regret (Muthukrishnan, A. V., 2015; Wassenaar, J., 2016). Johannes Spinnewijn also refers to inertia as ‘bounded rationality’ (Spinnewijn, J.,2012). A common example of this bias would be brand loyalty, where consumers are unwilling to change their mindset or attitude towards a brand despite changes in conditions of the product or their circumstances. For instance, when there is a change in pricing policies in a new insurance firm, such that the premium offered is more advantageous than that of the original contracted firm, the consumer may still be reluctant to change their provider. There exists distrust towards the new company which is not easily overcome once they have had a relationship with a company and they are unwilling to give up their personal information again.
Inertia is not to be confused with anchoring. Although they are both related to the decelerated or resistant process in rational decision making, anchoring is about subconscious linking of unrelated information such that the decision is affected while inertia occurs after a decision has been made and there is reluctance in changing that decision.
Behavioural economics helps to identify and explain the reasoning behind our not-so-rational decisions in real life, allowing us to predict the reactions of consumers and filling the gaps in traditional economics. It applies especially to the healthcare industry as healthcare is usually bought under random, urgent situations which leads to the vulnerability of the healthcare industry to the manipulation of providers if unregulated. The financial burden of critical healthcare procedures and costs is lowered by insurance that is bought in advance, but the purchase comes with risk (it is an investment after all). Hence, some behavioural biases of consumers behind insurance purchase have been given as overconfidence, anchoring and inertia, each of which deter us from buying insurance or cause us to mis-estimate our need for insurance.
Aretha Wan (18-I6)