Insurance products are tough to wrap your head around. In most cases you get nothing out unless the worst happens. There’s little likelihood of instant gratification. In fact, in the context of personal well-being, not ever needing to use these products would be the best outcome of all.
But unlike health insurance products (which we’ll discuss in the next section) the risk events covered by both long- and shortterm insurance products happen so rarely and unpredictably that we often fail to see the value in holding the insurance product at all. In each year, the vast majority of policyholders pay premiums but receive absolutely no monetary benefit in return. If insurance was viewed like an investment, policyholders would rationally feel like they had invested in a dud. The result is that where people have a choice about buying insurance, they often don’t.
Fundamentally, buying insurance is more about managing fear than making a financial decision, which is why it is so critical for an adviser to have a conversation with the individual that goes beyond product details.
If you add to this the fact that insurance premiums can run into several thousands of rands a month, you’ve got a conundrum on your hands: why should anyone buy an insurance product that cost a fortune, and provides only the promise of a benefit on the off-chance that the insured event happens at some point in the future?
Since the State offers limited protection against the asset risks that formal insurance products cover and often not at the level required by many employed people, it’s largely up to the individual to decide on the best way to manage these risks. The options available to the individual that the adviser needs to help navigate them through include:
Too often an adviser will jump to the first option of formal insurance products, without helping an individual to think through other options. In this chapter we examine a framework the adviser can use to help an individual trade off the various points against each other to see which option delivers the greatest value.
While different people have different risk tolerances, levels of adaptability and cognitive biases, there are good guidelines we can follow when helping them determine whether to buy an insurance policy. We need to answer two main questions to establish these guidelines:
Life is full of uncertainty and risks. There are various methods individuals use for dealing with the risks they face in life. The two most extreme modes for dealing with uncertainty:
The fear model may lead to people being overly cautious while the faith (denial) model can put them in serious danger of removing all safety nets. By identifying what mode an individual leans on most heavily, the adviser can help the individual to find a more moderate balance between them.
Most insured events are more likely to not happen each year than they are to happen. People tend to understand this. But do they really understand the probabilities? We have to turn to behavioural finance to understand how people determine the chances that an event will occur and therefore whether they need the protection.1
This term explains how people produce estimates. They start with an already established view on the occurrence of an event and will anchor to that view. This can lead to incorrect assessments of the chances of an event occurring.
This is the theory of how people make decisions when faced with risk and uncertainty. This moves away from traditional views of utility to a concept of value defined in terms of gains and losses relative to a reference point.
If we apply prospect theory to disability insurance for a 40-year old male, we would be comparing the following alternatives:
Although the two alternatives lead to the same expected outcome, people would choose alternative 2 because it has a smaller probability of occurrence, even though the potential loss is far greater than that under alternative 1.
The ease with which something can be brought to mind influences our judgement of how likely that event is to happen. For example, there may be more deaths from cancer than car accidents in this country, but car accidents are much more widely publicised, so we tend to believe that car accidents are more likely.
Myopic loss aversion
Myopic loss aversion refers to an excessive focus on short-term losses when a longer-term time frame, that acknowledges short-term losses, is more appropriate. This results in some people buying excessive amounts of insurance in the belief that the event may happen in the next year when it may only occur once every five years.
How can an adviser respond
Research shows that it is not the magnitude of the potential loss that leads people to buy insurance, it is the frequency with which the loss is likely to occur2. You can only respond appropriately if you perceive the risk correctly. How can we help individuals with that decision-making process?
Here are some points an adviser can include in their discussion with an individual:
An adviser can be critical in helping you assess whether you can cope with loss on the basis of the following questions. If our default position is no insurance coverage then the answers to these questions will help an individual to determine whether their savings, income or additional support systems would be adequate to provide the needed protection.
Is the maximum potential loss uncapped?
For certain types of loss events it’s simple to estimate how much cover is needed. Vehicle insurance should cover the value of your car, and life insurance should be enough to cover the daily living costs of your family after your death for a reasonable time period. In these cases an adviser can help an individual calculate whether they have enough savings or income to cover the expected loss. There are also instances where the loss might be unlimited. For example, you may experience a rare disease and your medical costs could run into the millions. Your savings would be inadequate.
Third party insurance is a specific type of cover that provides indemnification against losses incurred by someone else as a result of your actions. If you drive a car and you don’t decide to buy third party insurance, you could crash into a Ferrari and you may be liable for millions of rands in compensation. The upward bound of this type of liability is not known. Savings alone would be inadequate. Insurance should be treated as a priority.
Do you have enough emergency funds to absorb the loss?
If we return to the example of life cover above, we could calculate how much you need to cover your family’s daily living costs in your absence. You might consider factors like the outstanding bond amount on the house so that your family has somewhere to live; the cost of education for your children up to a university degree; estimated medical costs; and the cost of food, to name a few. We can then look at your existing asset holding to see if you have enough to act as a substitute for insurance. You might count the value of your retirement fund savings, emergency savings, existing cover from your employer, and so on.
The decision to buy insurance for losses that do have an upper limit depends on the assets you have at your disposal to absorb such a liability. Accumulating and managing these assets will often require the adviser to discuss an individual’s saving and investing decisions.
It isn’t always easy to assess all the costs that you could face if you experienced the loss event. When it comes to disability insurance, for example, there are many costs you may have to pay for, like physiotherapy, that you don’t think of when assessing whether you have enough money to offset the risk. This is where an adviser can help an individual to consider all angles.
Do you have social structures to support you should you incur the loss?
Some communities have strong social ties and sharing of medical costs and income support are common. If you’re comfortable relying on this support system to protect your family when you’re gone, you may be less inclined to buy life insurance. However, the costs you may incur are difficult to estimate with accuracy and can be unlimited. Consider how comfortable you are relying on such a support system. This is a very personal decision.
Will you be able to live your life as you wish if the insurable event occurs or could you adapt your lifestyle?
Humans are much more adaptable to losses than we think. If your cellphone is stolen, you could adapt and buy a cheaper one. However, if you don’t insure your car and it is stolen, would you be able to adapt to taking the bus? If you became disabled, would you be able to survive or adjust to a life with no income? You have to think about whether you could adjust your lifestyle without compromising your well-being.
When it comes to short-term cover for a home or a vehicle, specifically, if you are still paying off either of these assets, you should probably hold insurance equal in value to the asset themselves, or at the least, the value of the outstanding debt. If you were involved in a car accident and the vehicle is so badly damaged that it could not be repaired, you would be stuck having to pay off the outstanding amount on the car but wouldn’t have any car to drive.
If you conclude that formal insurance is the preferred option, here are the considerations that will provide peace of mind:
A helpful framework for advisers is to start with the presumption of no coverage and the interrogate whether the individual has adequate alternatives.
1 All descriptions of mental biases are adapted from the study material for actuarial examinations for subject F105, developed by the Actuarial Education Company.
2 Schade, Kunreuther Koellinger (2011)