Monday, 25 July 2011

To bet or not to bet? The psychology of gambling & its impact on insurance planning





Is insurance like gambling?

The gambling culture is deeply ingrained in Singapore culture.  From the occasional Toto punter to seasoned gamblers, Singaporeans are active participants where gambling is concerned. A recent survey conducted by Ministry of Community Development, Youth and Sports (MCYS) suggested that 54% of Singapore residents aged 18 and above have participated in at least one form of gambling over the past 12 months. A study of the biggest gambling losses conducted by the Economist in May 2011 has also revealed that Singaporeans are apparently not savvy gamblers. As a nation, we lost an average of $1,451 per person in 2010 in all legalised gambling activities, taking the number two spot in the world.

                It has been commented that gambling and insurance is similar in that once places a smaller amount of money in the hope of getting a disportionately larger return. Although the two activities are fundamentally very different, the behavioural tendencies that dictate how people make these decisions follow a similar pattern. A new branch of economics, known as behavioural economics, have termed these tendencies as behavioural biases.

We shall explore three behavioural biases most prominent among Singaporeans which applies to our attitudes towards gambling and insurance planning. They are:  framing effect, optimism bias and loss aversion.  

Framing effect

The most significant bias experienced by prospective clients is that of the framing effect of insurance benefits. Where gambling is concerned, the benefit is one of an immediate gain of the money wagered. One can immediately experience the joy of winning. 

Insurance, on the other hand, is a very irrational product whose benefits are not easily visualised. Is it an asset or a liability? Why is one paying premiums to cover an event they do not wish would happen (e.g. Death)?  Decision making behind insurance purchases is in direct conflict with many of our common product purchases. Would someone buy a TV and not use it? Or pay for a concert ticket when they have no intention of attending?  This bias is made worse as insurance itself is an intangible product. People in general tend to defer making a decision when a product is too complex and insurance is often left on the back seat.

Optimism Bias

Optimism bias refers to people’s tendency to be optimistic about the outcome of planned actions.
Have you seen a gambler who walks into a casino thinking he is going to lose money?  It is very unlikely as most people are filled with high hopes of making a windfall.  However we often see gamblers whom in hindsight stated that they should not have started gambling in the first place.  However, the realisation usually comes too late, after one has suffered significant losses.  Optimism bias always leads one to overestimate the chances of winning and underestimating the risks of losing.

The same logic applies for insurance, most people think they are going to live healthy and accident free lives and the thought of unfortunate events happening to them almost never crossed their minds. However, once a tragedy strikes, life insurance is no longer an available option for them.  The common understanding is that one can only buy life insurance only when they don’t need it.   This is a sad but true portrayal of reality.

Loss Aversion

The third behavioural bias is loss aversion, which states that people have a stronger tendency to avoid losses than to acquiring gains.  From a gambling perspective, it implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. A gambler in the red will usually continue gambling to break even, often resulting in higher losses. Even a gambler who is winning will constantly classify his chips into own money and house money, and his risk tolerance usually increase when he is playing with house money.

Hey wait! If people are more loss averse, doesn’t that mean people are more likely to buy life insurance? Since the purpose of insurance is to protect against huge financial losses from catastrophic events?

 Unfortunately, the thought process of a consumer on the street is even simpler than that. The reason why life insurance is so hard to market is because people compare paying insurance premiums as a guaranteed loss, while the insured event is just a possible loss. When one is faced with a small guaranteed loss versus a larger possible loss, as behavioural studies suggest, many will choose the option of taking a gamble and NOT buying insurance.  Many consumers end up taking a gamble on their financial future and find themselves severely lacking in insurance coverage when disaster strikes.

Insurance as a rational choice

A recent study conducted by Nanyang Technological University (NTU) in 2010 has revealed that an average Singaporean needs life insurance protection of $494,851. However, his existing life cover is only $165,628 on average, even after including mortgage insurance and CPF savings. This leaves a stunning shortfall of $329,223! This shortfall is also more apparent for families with young children.

                         Insurance Study conducted by NTU in 2010.

Industry experts have put forward several explanations as to why Singaporeans are so grossly underinsured. They include a higher emphasis on savings, investments, other day to day needs and education planning for children. I believe the main contributing factor towards the lack of proper insurance planning may perhaps lie in the gambling nature among Singaporeans and the behavioural biases we have discussed.

Insurance planning is an integral part of one’s financial plan. When it rains heavily, only pedestrians who brought along an umbrella can carry on life as usual. People who do not bother to carry an umbrella thinking the weather is always going to be fair always end up drenched.   We are all going to only live once; our lives and livelihoods are too high a stake for us to gamble it away with poor insurance planning. 

(See my other article: The downside of free financial advice)   
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