Insurance and Behavioral Economics: 

Improving Decisions in the Most Misunderstood Industry

Howard Kunreuther 

kunreuth@wharton.upenn.edu 

James G. Dinan Professor of Decision Sciences and Public Policy 

Co-Director, Risk Management and Decision Processes Center 

Wharton School University of Pennsylvania 

Federal Advisory Committee on Insurance

May 26, 2016

Washington, DC 

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Total number of declarations

Declarations associated with floods
Some insurance markets work well

• Term life insurance 

• Auto collision insurance 

• Homeowners’ insurance

But Low-Probability, High-Consequence (LP-HC) events 

puzzle consumers, insurers and politicians/regulators

• Consumers: Very limited personal experience with events

• Insurers: Ambiguous risks and correlated losses pose insurability 

challenges 

• Politicians/Regulators: Concerned with re-election and 

fairness/equity

What is Great and Not-So-Great about Insurance

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A Motivating Examples 

Purchase of Disaster Insurance by Homeowners

Most homeowners in flood-prone areas do not voluntarily purchase 

flood insurance – even when it is highly subsidized – until after they 

suffer damage from a disaster. 

Those who do not experience losses in the next few years are likely to 

cancel their policy. 

Demand for earthquake insurance in California increased significantly 

after the Northridge earthquake of 1994 – the last severe quake in the 

state; today, relatively few homeowners have coverage.

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Insurance today is not effectively meeting two of its most 

important objectives:

• Providing information to those residing in hazard-prone areas

• Incentivizing those at risk to invest in loss reduction measures

Factory mutual companies in the 19th century played these roles 

very effectively

• Required inspections of factories prior to issuing a policy 

• Poor risks had their policies canceled

•Premiums reflected risk and were reduced for factories that instituted 

loss prevention measures 

Key Roles of Insurance 

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How Can Insurance Encourage Loss Prevention?

Questions to be addressed:

•What are the decision processes that explain the actions taken by 

each of the interested parties based on the above three examples? 

•What are three guiding principles for insurance to encourage loss 

prevention prior to a disaster?

•How can the National Flood Insurance Program be modified to 

serve as a model for linking insurance and loss prevention measures?

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Linking Intuitive 

and Deliberative 

Thinking for 

Dealing with 

Extreme Events

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System 1 operates 

automatically and quickly 

with little or no effort 

• Individuals use simple 

associations including 

emotional reactions

• Highlight importance of 

recent past experience 

• Basis for systematic 

judgmental biases and 

simplified decision rules

System 2 allocates attention 

to effortful and intentional 

mental activities

• Individuals undertake trade-offs 

implicit in benefit-cost analysis

• Recognizes relevant 

interconnectedness and 

need for coordination 

• Focuses on long-term strategies 

for coping with extreme events

Intuitive Thinking (System 1) and 

Deliberative Thinking (System 2)

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Behavior Triggered by Intuitive (System 1) Thinking

 

Availability Bias – Estimating likelihood of a 

disaster by its salience

Threshold Models – Failure to take protective 

measures if perceived likelihood of disaster is 

below threshold level of concern

Imperfect Information – Misperceives the 

likelihood of event occurring and its 

consequences. 

Myopia – Focus on short-time horizons in 

comparing upfront costs of protection with 

expected benefits from loss reduction

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Many homeowners cancel their flood policy if they have 

not experienced a flood for several years.

Reason: Flood insurance was not a good investment.

Data: Of 1,549 victims of a flood in August 1998 

in northern Vermont, FEMA found 84% of residents 

in SFHAs did not have flood insurance. 

45% were required to purchase it.

Lack of Interest in Protection Against Disasters:

Cancellation of Flood Insurance Even When Required 

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New Business 

Year 2001 2002 2003 2004 2005 2006 2007 2008

Housing Units 841,000 876,000 1,186,000 986,000 849,000 1,299,000 974,000 894,000

1 year 73% 67% 77% 78% 76% 73% 74% 73%

2 years 49% 52% 65% 65% 63% 59% 58%

3 years 39% 44% 57% 55% 53% 48%

4 years 33% 38% 50% 48% 44%

5 years 29% 33% 44% 38%

6 years 25% 30% 33%

7 years 22% 26%

8 years 20%

Sources: Michel-Kerjan, Lemoyne de Forges and Kunreuther – Data from NFIP/FEMA

Note: our analysis of the American Community Survey reveals that the median length of residence 

was about 6 years over this period. 

Dynamic Analysis of Flood Insurance Tenure

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Provide better information on the role of insurance

• The best return on an insurance policy is no return at all

Use availability bias to focus on consequences

• Highlight financial problems if disaster occurred and the 

property were destroyed because it was unprotected and 

it was uninsured 

Overcome threshold model by stretching time horizon 

Example: Likelihood of 100 year flood

• Next year: 1 in 100

• 25 years: greater than 1 in 5 chance of experiencing 

at least 1 flood during this period

Aiding Decision Makers to Undertake 

Deliberative (System 2) Thinking

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Prior to the Loma Prieta earthquake (1989) only 22.4 percent of the 

homes had earthquake insurance. Four years later, 36.6 percent had 

purchased earthquake insurance—a 72 percent increase. 

One year after the Northridge earthquake of 1994, more than two-thirds 

of the homeowners surveyed in Cupertino County had purchased 

earthquake insurance. 

Consumer Behavior: Purchase and Cancellation of 

Earthquake Insurance

There have been no severe earthquakes in California 

since Northridge and only 10 percent of those in 

seismic areas of the state currently have coverage. 

If a severe quake hits San Francisco in the near 

future, the damage could be as high as $200 billion, 

and it is likely that most homeowners suffering 

damage will be financially unprotected. 12
Principle 1: Premiums reflecting risk 

– Signals to individuals the hazards they face

– Encourages investment in cost-effective adaptation measures

Principle 2: Dealing with equity and affordability issues 

– Provide vouchers to individuals requiring special treatment

– To receive vouchers, homeowners must mitigate their property 

to reduce future flood losses

Principle 3: Multi-year insurance contracts 

– Premiums reflecting risk with vouchers to deal with affordability

– Addresses myopia 

– Encourages investment in loss reduction measures through loans

Guiding Principles for Insurance

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Food Stamp Program 

Mission: Vouchers to purchase food based on annual income and 

family size 

Low Income Home Energy Assistance Program

Mission: Assist low-income households in meeting immediate energy 

needs 

Universal Service Fund

Mission: Provide discounts to low-income individuals in rural areas so 

rates for telecommunications services are comparable to urban areas

Insurance Vouchers: Existing Programs as Models 

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The National Flood Insurance Program (NFIP) Policy Problem

Interactions & 

interdependencies 

between the NFIP’s four 

functional areas create 

sustainable & mutually 

reinforcing reform.
Encourage Investment in Loss Reduction Measures 

•Risk-based premiums based on updated flood maps

•Home improvement mitigation loans tied to property

•Premium reductions for undertaking mitigation measures

Address the Affordability Issue 

•Means-tested vouchers for current residents

•Covers insurance premium and mitigation loan

•Condition for a voucher: You must mitigate

•Required multi-year insurance and loans tied to the property 

*Kousky, C., and Kunreuther, H. (2014). Addressing Affordability in the National Flood Insurance Program. Journal of Extreme Events 1(01).

Proposed NFIP Strategy for Reducing Future Disaster Losses*

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Dealing with Affordability in Ocean County, NJ 

(Population 580,000)
Family 1 is in the A zone and pays $4,000 for flood insurance.

Family 2 is in the V zone and pays $18,550 for flood insurance. 

•Both homes are 3 feet below Base Flood Elevation (BFE) 

•Each family has an annual income of $50,000 per year

Cost to elevate home to 1 foot above BFE: 

•Family 1: $25,000 20-Year 3% Loan (Annual Payment: $1,680)

•Family 2: $55,000 20-Year 3% Loan (Annual Payment: $3,660)

Means-tested voucher covers insurance and mitigation costs above 

$2,500 ( i.e., above 5% of income) 

Two Families Residing in Ocean County, NJ

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Cost to the Federal Government and the Two Families

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Estimates of Program Costs for Ocean County Tracts 

that Experienced Storm Surge

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Homeowner: Lower total annual payments

NFIP: Reduction in flood losses 

 Financial institution:

 More secure investment due to lower losses from disaster

 Federal government:

 Lower voucher costs due to reduced insurance premiums 

because property is mitigated (e.g., elevated; flood-proofed)

General taxpayer:

 Less disaster assistance 

Everyone is a Winner

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Challenge Between Today and 2017 

When National Flood Insurance Act is Up for Renewal 

Long-term strategies for reducing flood risk, given climate 

change (e.g., sea level rise)

(Deliberative thinking)

Short-term incentives for encouraging this behavior 

(Intuitive thinking)

Develop risk management strategy that recognizes the 

importance of equity and affordability 

(Policy analysis)

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Future Challenges and Questions for Discussion 

LONG-TERM ISSUES 

How long will it take FEMA with its partners, including the private sector, to develop 

new hazard maps that more accurately assess the risks of flooding?

How costly will affordability programs be to the public sector and residents in floodprone areas in the United States?

SHORT-TERM CHALLENGES

How can the impacts of climate change be incorporated in designing flood insurance 

to encourage investments in adaptation measures? 

What are the most appropriate ways of dealing with affordability issues?

• What empirical data should be collected?

• What controlled experiments/surveys should be undertaken? 

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Insurance can help spread the risk of unavoidable disasters and offer 

incentives to mitigate risk.

The National Flood Insurance Program faces challenging questions 

with respect to implementing mitigation measures and addressing 

affordability issues. 

We need to encourage deliberative thinking by focusing on the 

long term while providing short-term incentives for acting now,

rather than waiting by assuming it will not happen to me.

Conclusions

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The Challenges of Linking Flood Insurance 

with Adaptation Measures

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Part I: Contrasting Ideal and Real Worlds of Insurance

Chapter One: Purposes of this Book

Chapter Two: An Introduction to Insurance in Practice and Theory

Chapter Three: Anomalies and Rumors of Anomalies

Chapter Four: Behavior Consistent with Benchmark Models

Part II: Understanding Consumer and Insurer Behavior

Chapter Five: Real World Complications

Chapter Six: Why People Do or Do Not Demand Insurance

Chapter Seven: Demand Anomalies

Chapter Eight: Descriptive Models of Insurance Supply

Chapter Nine: Anomalies on the Supply Side

Part III: The Future of Insurance

Chapter Ten: Design Principles for Insurance

Chapter Eleven: Strategies for Dealing with Insurance-Related Anomalies

Chapter Twelve: Innovations in Insurance Markets through Multi-Year Contracts

Chapter Thirteen: Publicly-Provided Social Insurance

Chapter Fourteen: A Framework for Prescriptive Recommendations

Insurance and Behavioral Economics: 

Improving Decisions in the Most Misunderstood Industry

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