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Taking A Closer Look

James Portelli takes a broad look at behavioural attitudes to risk, with references to AIG, Lloyd’s and the Dubai real estate market.

In a previous Policy article I had used the term “insonomics” with reference to the economics of insurance. It hasn’t yet found its way into the English dictionary so I am penning yet another term, “psychonomics”, to see which one makes it there first.

The theory of demand is a recurring theme in economics. The grandfather of economics, Adam Smith aptly sums it up as: “The sole objective of production is consumption.” Central to the theme of demand is the concept of “effective demand”, ie not just the willingness or desire to have a commodity, but the ability to pay for it. However, the importance we place on price (and one’s ability to purchase) often over-shadows the theory of “utility” which is perhaps a more fundamental concept to the theory of demand. Perhaps an eloquent way of comparing price and utility would be to state that price is the value attached by the supplier whereas utility is the value attached by the consumer. Therefore the latter has more to do with human belief and behaviour and less to do with money. At a micro-level economics is very much driven by human behaviour; in other words, psychology; hence the term psychonomics.

But what does all of this have to do with risk or insurance? In insurance we have buyers, sellers, intermediaries (and regulators, of course). This implies that we have all the constituents of a micro-economic market. Furthermore, although insurance companies or intermediaries supply insurance, customers are not seeking insurance, but a solution to the problem of risk.

Insurance is only one solution. Therefore, insurance market activity (as well as the abstract notion of risk) suggests that “utility” (based on human perception and ensuing behaviour) play a very important role in economic decisions surrounding risk and insurance.

Various studies have been conducted over the years on how people interpret the world around them, how this effects judgements and decisions they make and how they consequently “frame” their actions. The following are some examples of human behaviour manifesting itself in subjective judgement drawing examples from the risk and insurance environment around us.

A) Selective attention — This refers to the ability to tune in to experiences or information that is of interest to a person while blotting out what are perceived as irrelevant stimuli. By way of example, Lloyds of London (Press Release LL20, 24/09/2009) recently announced that “pre-tax profits at Lloyds for the first half of 2009 rose by 39 per cent.” The CEO is quoted as attributing this, in part, to “Lloyd’s prudent and conservative approach has ensured our capital position and ratings remain strong.” The press release further frames this within the context of “continued underwriting discipline.”

However, the fact the pre-tax profit increased despite a drop in underwriting profits when compared to the first half of 2008 suggests that this, in fact, is not entirely correct. While making reference to some objective reasons for better overall results (ie lower catastrophe losses in 2009), the press release omitted to focus on other real and objective reasons why pre-tax profits increased, namely the weakening of the British pound (making reinsurance purchases from the UK more attractive), market-wide improvement in investments in 2009 compared to the end of 2008 and a change in reinsurance buyer behaviour as a result of the financial melt-down. Buyers are departing from the “eggs in one basket” purchasing behaviour with the AIGs of this world to a wider and more diversified reinsurance protection portfolio through a subscription market such as Lloyds. The focus on “continued underwriting discipline” as the underlying reason for the strong first half results is, therefore, an example of selective attention.

B) Selective exposure — Selective exposure defines the behaviour of persons gravitating towards information that, framed within a current context, seems more directly relevant. An example of this may be derived from some of the findings in the Marsh and Governance Metrics International survey (The Importance of ERM during Economic Upheaval, February 2009). One of the findings notes that “67 per cent of companies who have a formal ERM programme in place initiated this between 2004 and 2007.” Putting this within a time context, this was a period of heightened ERM awareness because of “publicised corporate failures and the release of the COSO ERM Framework.”

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