Behavioral finance, actuarial science and you
By Mike Boot
Society of Actuaries
Financial planners and producers are key players in setting a benchmark that will be studied for years to come. The impact and lessons learned from the current financial crisis will be closely scrutinized by many people. One segment of the industry that is carefully looking at the shock effects is the field of behavioral finance, a practice that combines psychology and economics to explain why and how consumers act, and to analyze how their behavior affects the market. This all boils down to the need for balance in managing risks and not shutting out opportunities.
Actuarial science relies heavily upon the use of economic models, but oftentimes, the real world is not so convenient. Actuaries rely on other academic and economic work to modify their models in order to deal with a complex and sometimes irrational world. Just as actuaries are looking to use discoveries from behavioral economics, so should every financial planner also study a number of key themes, as noted at a recent session during the Society of Actuaries' 2008 Annual Meeting. Donald Krouse, FSA, MAAA, vice president and actuary from AEGON USA, along with University of Illinois Psychology Professor Dr. Neal Roese, PhD, presented the session "A Behavioral Finance Perspective on Actuarial Science" on this behavioral finance concept.
Krouse and Roese presented five main themes from behavioral finance at the conference in October. The first theme is choice. Some choice is viewed positively from consumers, but too many choices can be overwhelming. Research shows that 401(k) participation does not increase with the number of investment options. In fact, participation often declines when the number of funds offered increases to more than 30. With many of the complex options available in certain insurance products, including indexed products, the range of possible combinations can easily reach more than 100. It is in producers' best interests that they determine customers' key financial goals and present only a handful of options, versus sharing all possible existing combinations.
The second key theme is framing. The way a problem or decision is presented to decision-makers will affect their actions. For example, if people are given the option of choosing $7,000 or taking an opportunity to have an 80-percent chance of receiving $10,000 and a 20-percent chance of receiving nothing, the majority of people will choose the certain outcome of $7,000.
This is often frustrating when looking at the expected value of the "risky" outcome as being higher. However, when the problem is presented as having the option of paying $7,000, or having a risky outcome with an 80-percent chance of paying $10,000 and a 20-percent chance of paying nothing, many people select the risky outcome even though the expected payment will be larger. In general, losses are more painful than gains are pleasurable, meaning people are risk-averse to gains but are risk-seeking to losses. This behavior is important for all financial planners to understand because insurance is inherently a "loss frame" mindset, but perhaps you can shift the focus to a "gain frame" perspective by getting customers to focus on an investment goal and its future gains.
The third theme from Krouse and Roese is heurtistics -- solving a problem that leads to learning and discovery. Events that are vivid or easily imagined are judged to be more likely than equally probable events. The classic example is that people tend to overstate the probability of death from flying versus death from driving, since when a plane crash occurs it is newsworthy and very vivid. One aspect of this is that the unexpected often captures our attention. This is the ideal time for financial planners, in the wake of very vivid pictures of losses from the financial crisis, to approach customers with a simple, atypical request to stimulate "safe" options.
The fourth theme is timing. Most people value money in-hand today. People will often take $1,000 now versus $1,500 two years in the future, even though actuaries will tell them that the present value of the future payment is higher. This is challenging with respect to life insurance, because death is perceived as happening in the distant future. Rather than making the future abstract, it is important to focus on concrete details in the future and to emphasize the minimal impact that it might have today on an individual's lifestyle.
The fifth theme that Krouse and Roese presented was optimism. People think they are more likely than others to have good outcomes and less likely to have any problems. Researchers found that 90 percent of the general public viewed themselves as above average, even in areas where they had no training or expertise. The outdated insurance expression of "buy term and invest the rest" played into customers' perceptions that they would be great investors. Too often customers did not invest any funds or now find that the investments have resulted in large losses. With the fear of the financial crisis, the timing is ideal for customers who may want an insurance company to manage their funds. Some customers will now be more open to the returns of a universal life policy, since they have recently been opening their fund balance statements and seeing losses.
Sentient Decision Science conducted research on more than 9,300 individuals and families in the last two years. It found that the practice of saving increases financial optimism. Even among those with the lowest current savings balance, 57 percent of those who consistently put money into savings expressed optimism about their financial future. The research also indicated that with a financial plan, confidence grows. Almost half (45 percent) of the survey respondents with a financial plan reported feeling "very" or "extremely" secure financially, compared to only 315 of respondents without a plan. There is a clear opening today to help your customers develop a full financial plan so they can find some financial security and confidence during these uncertain economic times that have shattered customers' overconfidence in their own investing abilities.
After the events of September 11, 2001, insurance companies found customers fearful for a few months. This led to a temporary effect of lapse rates slightly decreasing and an uptick in the purchase of life insurance, along with customers shifting funds from variable annuities to fixed annuities. With the effect of the financial crisis over the past couple of months, companies have again seen the shift from variable annuity to fixed annuity purchases. Other shock effects are still being measured and played out on a daily basis with policyholders.
As a producer, this is a very challenging time. However, knowing some of the principles of actuarial science, as well as having the knowledge of psychological biases of behavioral finance, can help with understanding and reassuring customers during these turbulent times. This provides an opportunity to influence them to make better informed decisions, and help provide greater balance with risks and rewards.