Why insurance is the most misunderstood industry?

Wharon Profs.  Howard C. Kunreuther and Mark V. Pauly, have co-authored a book titled, Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry.

In this interview, they say why insurance is the most misunderstood industry. Some think it like investments, others do not insure as events are low probability:

Knowledge@Wharton: In the subtitle of Insurance and Behavioral Economics, you jointly refer to the insurance industry as ‘the most misunderstood industry.’ Broadly speaking, how and why is insurance so widely misunderstood, at least in the United States?

Howard Kunreuther: I think that people view insurance as an investment rather than as a protective activity. That is one of the basic misunderstandings. As a result, if they haven’t collected on their policy, they will cancel it because they feel that, in some sense, it was not a good deal — rather than [acknowledging] that the best return on a policy is no return at all. That is one aspect. The other feature is that on the very low-probability events, which is where insurance is most valuable, people say [a low probability event] is not going to happen to me. I don’t have to worry about it. I won’t protect myself.

Knowledge@Wharton: Mark, would you care to comment on these issues?

Mark Pauly: Insurance is different. When I go out and buy a clothes dryer, I put down my money. In a few days, the clothes dryer shows up at my house, and it is what I ordered. That’s that. But with insurance, you put up your money in the first instance, and if you are lucky, you get a cheesy piece of plastic that indicates you have insurance coverage. But what you are going to get is determined later by whatever happens. Once a bad event occurs, it is easy for people to forget the details of what they agreed to when they put down their money, and to think that they should be entitled to things that may not have been covered in the contract.

That’s not the only example where people sign long-term contracts. But it is a good example, and it is actually worse than most long-term contracts, because the whole intrinsic idea is that uncertainty and unpredictability will intervene, which makes it easy for people to be confused about whether they made a smart decision in the first instance.

The nature of insurance, of course, is that in a sense, everybody who buys insurance makes a dumb decision. Either you paid your premium, and then you didn’t suffer a loss — we claim that the best return from insurance is no return at all — or you did pay your insurance and you suffered a loss, and you wish that you hadn’t, because [the insurance] didn’t cover everything. Either way, people tend to be dissatisfied.

Insurers also sometimes misunderstand their business, particularly when dealing with catastrophic events. Regulators of insurers often misunderstand insurance as well because, like the rest of us, they want it to do everything good in the world. But sometimes, that’s not always possible.

There are lessons from beh econ as well:

Knowledge@Wharton: Mark, with respect to health insurance reform, do you think the framers of the ACA really looked into the challenges of health care reform through the lens of behavioral economics? As an economist who specializes in this, you are used to thinking of it that way. But are other people who make policies sometimes just not getting it?

Pauly: Policy makers in general have a hard time dealing with insurance. Because the simplest thing – if you observe something that looks like a mistake – is just to pass a law to make people do it. But as Howard just pointed out in the case of the regulation on flood insurance, it then often becomes very hard to enforce the regulation or very hard to get people to abide by it. I think the same thing is going to happen with the mandate to buy health insurance because it is relatively modest and because people will claim that they cannot afford it. That is why they are not doing it despite what the law says. It makes it hard to deal with insurance just by wielding a stick. So behavioral economics basically says, let’s look at a much broader set of restructurings that can make insurance attractive as well as something your mother told you that you should do, but you just have not gotten around to doing, which is how most of us look at it.

There is another one on website design as well..

Nice info on insurance industry..