Behavioral Economics and

Insurance Regulation

Tom Baker

FACI May 2015
Econ? Human! Dunce?
Baker & Siegelman, Behavioral Economics and Insurance Law: The Importance of 

Equilibrium Analysis, in Handbook of Behavioral Economics and Law, Eyal Zamir and 

Doron Teichman, eds., (2014) 
Anomalies (Relative to Econs)

• Insurance against irrationally small risks

– Deductibles that are too low

– Extended warranties

• Shadow deductible

• Insurance for emotionally treasured objects

• Preference for no-claim rebates & deferred 

dividends

• Preference for insurance against named risks

• Underinsurance for infrequent big risks (flood)
Biases affecting perceived value

• Excessive discounting (decrease value)

• Over optimism (decrease value)

• Loss aversion (increase value)

• Emotional attachment (selective increase)

• Availability heuristic (depends)

• Regret aversion (increase value for frequent small 

losses; decrease value for infrequent large losses)

• Threshold effects (depends)

• Overconfidence/Control illusion (depends)
Information processing issues

• Hyperbolic discounting

• Complexity aversion

• Aversion to contemplating some topics 

(death)

• General cognitive constraints relative to the 

information demand needed to assess value
How to help Humans?

• Insurance economics still provides the best guide 

to when insurance is worth it

• Multiple biases/cognitive limits pointing in 

different directions

• Assuming we understand the relevant 

biases/cognitive limits:

– De-biasing & overcoming limits are very difficult

– Can the market be structured to reduce the impact of 

the bias or cognitive limit? Sometimes.

– Does it need to be? Not always.
Extended Warranties vs. 

Low HO Deductibles

• Similarly irrational for an Econ to purchase

• Similar BE explanations for why Humans purchase:

– Regret aversion

– Mental accounting

– Loss aversion

– Availability heuristic

• BUT very different market context:

– Shrouded pricing (situational monopoly) for extended 

warranties means price is WAY above cost

– Low deductible HO leads to actuarially rational risk 

segmentation, so price is in line with cost

– See Baker & Siegelman, “You Want Insurance with That?” Using Behavioral Economics to 

Protect Consumers from Add-On Insurance Products, 20 Conn. Ins. L. J. 1 (2013) (relied 

on by the FCA in General Insurance Add-Ons Market Study, MS 14/1)
BE ideas for annuities

(Market is already doing this)

• Optimism bias + over confidence = I can do 

better by saving/investing than giving my $ to 

insurers

– Scare stories (availability heuristic)

• Loss aversion: premiums are framed as losses.

– Reframe premiums as an investment

• Regret aversion: what if I die too soon?

– Provide death benefits
APPENDIX

Why Prices are So Far Above Cost

• Shrouded pricing 

• Stage 1 Base product

– Advertised, competitive pricing

• Stage 2 Optional, secondary purchase

– Situational monopoly pricing
Regulatory Approaches to EW

• Enhanced disclosure

• Ban point of sale purchase of add on

• Price regulation

• Open up the situational monopoly
FCA’s Market Study

• Require firms to make public their claims ratios

• Ban point of sale purchase for certain services

• Ban pre-ticked boxes

• Price comparison websites