Thinking fast and slow about terrorism insurancePosted: December 1, 2011 Filed under: behavioral economics, cognition, Corporate strategy, economics, psychology 6 Comments
This morning, my colleague Josh Gans and I sat in on a general audience talk by Daniel Kahneman about his new book Thinking Fast and Slow. It was interesting to see how the research agenda has progressed and evolved over the past couple of decades. This idea explored in this book, and in the talk, is that cognition can be broken into two “systems” — one that responds instantly and without effort and another that responds with will and effort. The example given to distinguish between the two was being asked to answer the following questions: (a) what is 2 + 2? and, (b) what is 17 x 24? The first comes unbidden and effortlessly to mind. The second requires conscious effort (which has several physiological traits associated with it, such as significant pupil dilation).
Kahneman is a terrific speaker and these issues are inherently fascinating. One of the examples raised a puzzle in Josh’s mind. The example is asking air travelers whether they want to buy insurance. When asked how much they are willing to pay for $100,000 worth of life insurance for an upcoming flight covering death due to any reason, subjects report a number. When asked how much they are willing to pay for $100,000 worth of insurance for death due to a terrorist attack (only), they report a substantially higher number. The reason given for this is that the “fast” system associates terrorism with fear and fear motivates higher willingness to pay for insurance.
The puzzle is: why do insurance companies specifically exclude terrorist acts from life insurance policies? Presumably, a”slow” thinking group of insurance executives could cash in on the “fast” thinking bias of travelers by inducing impulse purchases of terrorist insurance at ticket kiosks at the time of check-in. Yet they don’t. Having recently had some problematic insurance company dealings, Josh’s “fast” thinking answer was that insurance company execs are not very skilled decision makers. I am open to a more rational reason, though I cannot think of what it would be.
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Insurance people are mostly better at underwriting (cost reduction, risk aversion, etc) than at understanding consumers. Most of the insurance industry has indeed arisen out of the natural market opportunity created by the gap between fast and slow thinking – but my sense is this has happened without the conscious awareness of most insurance executives. Though markets do work, and once someone starts offering terrorist-inclusive insurance and wins all the business, others may well jump in.
However, there are two other more rational explanations which you might prefer:
– holidaymakers whose attention is drawn to terrorism risk may not want to go on holiday at all. Perhaps if insurance is mainly sold through travel companies, the latter may not want the insurer to promote that feature.
– unlike ski accidents or stolen luggage, terrorism risks are (relatively) highly correlated. If a plane is blown up with 400 people aboard, a small number of insurers are likely to be on the hook for a huge payout. These things can be reinsured, but perhaps not that easily. So the insurance business model may become too risky if this risk is taken on board.
Good points, Leigh, not to mention that black swan events, such as terrorism attacks are difficult to quantify from a risk (versus Knightian uncertainty) perspective thus making premiums difficult to set.
I always thought it was the same reason that commercial GL politcies exclude natural disaster and war damage – they can’t price for something like this where the likelihood is so small but the consequences could equal bankrupting the firm (if they had significant market presence in a city that got nuked, e.g.) if that small likelihood pans out.
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Uh, guys, have you considered moral hazard? It’d be like offering life insurance that covers suicide. Great new funding mechanism for bad guys–put four passengers on a flight who all buy terrorism insurance, then take out the plane.