continued
skin cancer reduces their risk of cancer is less effective than
warning them of the increased risk that results from failing
to self-examine. Insurers engage in a type of framing all the
time. For example, offering a good-student discount for auto
insurance is logically equivalent to surcharging policyholders
who don’t fall into the good-student category. But few insurers
would adopt the latter option.
As if all of this weren’t enough, there is an entirely different class of ways in which people regularly diverge from the
rational ideal—they succumb to social influences even at the
cost of ignoring information from their own senses. So-called
conformity effects have been studied since the 1930s and appear to be fairly ubiquitous. They (at least partially) account for
phenomena as disparate as vicissitudes in fashion, the success
of anti-littering and anti-graffiti campaigns, and even the decision-making of federal judges. Other well-known conformity
effects, documented in research from Harvard, the University
of California, San Diego, and other sources, include the fact that
obesity is contagious (controlling for other risk factors, people
with overweight friends are more likely to be overweight themselves) and the fact that teenage girls who see their peers having
children are more likely (again, all else being equal) to become
pregnant themselves.
A disconcerting finding is that even core beliefs appear to
be subject to social influences. For example, Thaler and Sunstein report a study in which people were asked whether they
agreed or disagreed with the statement, “Free speech being a
privilege rather than a right, it is proper for a society to suspend
free speech when it feels threatened.” When this question was
posed individually to people in a control group, only 19 percent
agreed with it. However, when another group was told that four
other people agreed with the statement, 58 percent agreed.
For a more mundane example, think back to Francis Galton’s
ox contest. Galton’s contestants were “rational” because they
made their guesses independently of one another. However,
had the first contestant uttered an inaccurate guess out loud,
it very likely would have anchored others’ guesses, resulting in
the average of the crowd’s guesses being biased. Even worse, if
the guesses had been made both aloud and in sequence, an “
information cascade” might have arisen, resulting in the group’s
collective estimate being highly sensitive to the guesses of the
first few members. Consider this the next time you are in a
group discussing a job candidate or an employee’s year-end
review.
Finally, people regularly diverge from the rational ideal
of Homo economicus in demonstrating a lack of self-control.
People have trouble staying on diets, don’t get around to properly organizing their retirement saving plans, and continue to
smoke in spite of the dire and well-publicized risks involved.
Thaler and Sunstein report an amusing experiment that drives
the point home. Two groups of people in a movie theater were
given free bags of tasteless, stale, squeaky popcorn. One group
received big bags, the other smaller bags. The recipients of the
bigger bags ate 53 percent more popcorn, even though none of
them liked it! One is reminded of a joke from Woody Allen’s
Annie Hall, “Two elderly women are at a Catskill mountain
resort, and one of ’em says, ‘Boy, the food at this place is really terrible.’ The other one says, ‘Yeah, I know; and such small
portions.’”
Anchors Away
All of this might be interesting, but, other than the incidental
connections made above, how does it relate to insurance? At
least three types of connections are worth considering.
■ Classical economics forms part of the theoretical background of actuarial science, insurance management theory,
and regulatory work. Fundamental changes in economics
will probably have ripple effects on academic and applied
actuarial work.
■ Perhaps the most notable development in actuarial science
in the past decade has been the profession’s embrace of
modern predictive analytics. Some of the success of predictive modeling in insurance is related to bounded rationality
and the heuristics and biases discovered by Kahneman and
Tversky and their followers.
■ Thaler and Sunstein point out that an improved understanding of people’s cognitive and behavioral biases can
be used—through what they call “choice architecture”—to
help people make better decisions. Their point is especially
relevant to insurance-purchasing decisions.
Let us consider each of these themes in turn.
A paradigm shift for economics—If behavioral economics continues its rapid growth in stature, its importance to insurance,
as well as medicine, law, regulation, and many other areas of
business, is likely to be substantial and wide-ranging. This is
precisely because behavioral economics strikes at the very heart
of classical economic theory.
An analogy might be useful. In a sense, the doctrine of rational expectations is reminiscent of the ancient astronomers’ central tenet that planets move in perfectly circular orbits. This notion seemed axiomatic at the time because of the astronomers’
prior commitment to the philosophical doctrine that circular
motion is the most “perfect” motion and therefore uniquely
suited to “heavenly” bodies. From a modern perspective, it is
the reasoning that seems circular. Physics ultimately dropped
this philosophically motivated axiom in favor of the more accurate premise that planets move in elliptical orbits. The Newtonian revolution in physics would have been impossible, and
