Reckoning with Risk (3)

Note: An earlier version of this post appeared here.

When people calculate the risk of hurricane damage and make decisions about hurricane insurance, they consistently misread their prior experience, as reported by The Wall Street Journal. This conclusion comes from a paper by Wharton Prof. Robert Meyer that describes and reports on a research simulation in which participants were instructed that they were owners of properties in a hurricane-prone coastal area and were given monetary incentives to make smart choices about (a) when and whether to buy insurance against hurricane losses and (b) how much insurance to buy.

Over the course of the study (three simulated hurricane “seasons”), participants would periodically watch a map that showed whether a hurricane was building as well as its strength and course. Until virtually the last second before the storm was shown to reach landfall, the participants could purchase partial insurance ($100 per 10% of protection, up to  50%) or full coverage ($2,500) on the $50,000 home they were said to own. Participants were advised how much damage each storm was likely to cause and, afterward, the financial consequences of their choices. They had an unlimited budget to buy insurance.  Those who made the soundest financial decisions were eligible for a prize.

The focus of the research was to determine whether there are “inherent limits to our ability to learn from experience about the value of protection against low-probability, high-consequence, events.”  In other words — tail risk. Sadly, we don’t deal with this type of risk management very well.  Our experience helps us somewhat, at least temporarily, but we typically misread that experience over time.

The bottom line is that participants seriously under-protected their homes. The first year, they sustained losses almost three times higher than if they had bought protection rationally. A small portion of these losses were the result of over-insuring.  But the key problem was a consistent failure to buy protection or enough protection even when serious and imminent risk was obvious.  Moreover, most people reduced the amount of protection they bought whenever they endured no damage in the previous round, even if that lack of damage was specifically the result of having bought insurance.

Experience helped a little.  Participants got better at the game as season one progressed, but they slipped back into old habits when season two began. By season three, these simulated homeowners were still suffering about twice as much damage as they should have.  As Meyer’s paper reports, these research results are consistent with patterns seen in actual practice. For example, the year after Hurricane Katrina there was a 53% increase in new flood-insurance policies issued nationally.  But within two years, cancellations had brough the coverage level down to pre-Katrina levels.

These findings should give us all pause.  They have significant implications for insurance of various types — whether hurricane insurance, other hazard insurance, life insurance or even portfolio insurance (either via the purchase of options or by “taking risk off the table”).  These findings may also offer some insight into the “annuity puzzle” (economists have long been baffled that people buy income annuities far less often than reason suggests they should).

We don’t do a very good job dealing with low-probability, high-impact events, whether hurricanes, early death, or market bubbles.  We are consistently overconfident and, due to the bias blind spot, think these inherent problems may exist generally, but don’t pertain to us.  At a minimum, this suggests that we might all be more cautious than we tend to be and that we all ought to consider the use of accountability partners since we all see problems and weaknesses in others far better than we see them in ourselves. We simply don’t deal with risk very well. Remember, risk is risky.

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