Personal insurance, such as, Life, Disability, and Critical Illness, is commonly sold by indiscriminately pointing to the potential financial losses by not having the coverage. Hardly ever do the customer’s risk exposure and risk appetite enter the equation. They should no longer be neglected. In times of tight money in inflation-ridden economies, such additional information may be vital in providing cheaper, tailor-made solutions to the growing number of potential customers who are unable to afford the comprehensive insurance covers predominantly on offer.

How can insurance customers today deal with what economists call their budget constraints?¹ Consider the following purchase options:

1. All recommended covers but for lower amounts than necessary.
2. Some of the recommended covers but for the required amounts.
3. All recommended covers at the expense of non‑insurance goods.
4. All recommended covers for a limited scope of insured risk.

Option 4 warrants a closer look – not only because it calls upon insurers to come up with attractive carve-out products but also because it invites us to think about customer needs in a hitherto neglected way. For even in the absence of budget constraint, it may be wise for customers to take out cheaper carve-out products and spend more money on non‑insurance goods.

But they must be able to make informed and rational decisions about the risks involved. Are they? There appear to be three schools of thought.

Traditional economics posits that customers are rational. They will be able to maximise their welfare only if they are free to choose between alternative options. Under these circumstances, increasing the number of options is invariably beneficial. The level of welfare will rise – if customers consider the additional options preferable to the existing ones, or will remain unchanged – if the initial choice is not revised. Through their purchase behaviour rational consumers reveal their preferences. Goods are bought and sold as long as all parties benefit from the transactions. A free market economy therefore maximises the wellbeing of its participants.

In recent years this traditional view has increasingly come under fire. Drawing on the findings of research programmes already starting in the 1970s psychologists and behavioural economists have been able to establish systematic deviations from rational behaviour, so‑called heuristics (rules of thumb).² If consumers can no longer be considered as rational according to the traditional view, supervisory authorities and governments will be called upon to introduce corrective measures for the benefit of individual and collective welfare. This so‑called paternalistic approach has, for example, been fully embraced by supervisory authorities in the Netherlands, the UK and, to a lesser degree, in Germany.³

Advocates of paternalism have, in turn, been criticised by a third school of thought, whose adherents do not deny the findings of behavioural economics but arrive at different conclusions. Rather than asserting that economic decisions are flawed whenever they deviate from the rational model, they see a lot of wisdom in using rules of thumb, notably under conditions of uncertainty or budget and time constraints. According to these experts, people are not hopeless at understanding risk, as the paternalistic view seems to imply, but need to be properly trained from an early age to become “risk‑savvy”.⁴

What could a transparent insurance proposal for risk-savvy customers look like? Consider Figure 1 below, which depicts the age-dependent share of a carve-out disability product (CI) in total disability incidence.

In this sample cover, disability must be caused by any one illness from a list of insured critical illnesses, e.g., cancer or heart attack, to qualify for further claims assessment. Figure 1 provides useful information to the prospective client because it shows that:

• In younger disability claimants, the insured critical illnesses represent only a small fraction of total incidence, with the remainder mainly consisting of disorders of the psyche and the musculoskeletal system.
• The carve-out product is bound to be much cheaper than a comprehensive cover.
• The relevance of the carve-out cover increases with age.

Such a product clearly offers advantages to all those who consider their chance of developing psychological or locomotive problems as low, for example, because they trust their healthy lifestyles and their favourable family histories. These customers would be happy to retain more risk in exchange for lower premiums.

For another example, consider a comparison of a comprehensive disability cover with a functional carve-out cover as depicted in Figure 2.

In this sample cover benefits will be paid if the insured suffers from the permanent loss of one or more essential abilities such as hearing, speech, sight, walking and standing, or becomes in need of long-term care. The occupational impact does not enter the claims assessment. The three takeaways from Figure 1 also apply to Figure 2, but they are each comparatively less pronounced. Our second sample product will likely be more suitable for customers who, for example, are primarily concerned about accident-related disabilities and want the benefit payment to be dissociated from their occupational impact.

Depending on the products under consideration, there are multiple ways of making a prospective customer’s risk exposure transparent, thus facilitating a reasonable balance between insurance and risk retention. Much of the mis-selling in recent years may indeed be attributable to ill-informed rather than irrational customers. This appears to be a cue supervisory authorities should explore further, rather than focus on paternalistic policies. Risk literacy in customers and risk transparency in insurance products are important factors in enhancing the welfare gains of insurance markets.

Endnotes

1. For instance, single-person companies in the Netherlands, half of whom do not have any disability insurance because they cannot afford comprehensive covers.
2. For an example see Daniel Kahneman, “Thinking, fast and slow”, 2011, p.7.
3. Financial Conduct Authority, “Applying behavioural economics at the Financial Conduct Authority”, Occasional Paper No. 1, April 2013. Autoriteit Financiële Markten, “Standaardproducten en financieel beslisgedrag van consumenten, een gedragswetenschappelijke analyse”, January 2015. “Bundeanstalt für Finanzdienstleistungsaufsicht”, Speech by Elke König at the BaFin Annual Press Conference 2014, https://www.bafin.de/SharedDocs/Veroeffentlichungen/EN/RedenInterviews/re_140520_jahrespressekonferenz_p_en.html, last accessed 16 Nov. 2022.
4. See e.g. Gerd Gigerenzer, “Risk-Savvy: How to Make Good Decisions”, 2015. In his book Gigerenzer renders an account of how in 2009 flight captain Chesley Sullenberger famously saved his passengers from certain death by using rules of thumb when he decided to ditch his aircraft in the Hudson River after both engines had been disabled by a bird strike.