The economic models conventionally assume that people are rational in the sense that they have coherent preferences and should make decisions in a specified fashion. In reality, the decision makings usually involve with the complicated situation, confusion, and emotional conditions which can lead the people to deviate from the rationality. That is, Kahneman and Tversky (1973) proposed the Prospect Theory to study such “irrational” behaviors in managing risk under uncertainty. They posit that deviations from rationality stem from emotion and perception. Moreover, the difference states of emotion and perception can make people to concentrate on each component of a problem separately rather than looking at the whole picture, so- called “mental accounting”. Failure to recognize that the aggregate is a result of interaction among its components leads to the deviations from rationality.
The Framing Effect states that people decision making depends upon the setting of problems. People exhibit risk-aversion when a choice is presented in one setting and display risk-lover when the same choice is framed in a different manner.
For example, people are willing to take a risk when the problem is framed in view of gain and to avoid the risk when the same problem is framed in form of loss. Prospect Theory explains such asymmetry of decision making that people are not risk-averse, yet they are loss-averse. It is not the uncertainty that people try to avoid, rather they dodge from losing. He noted that people reveal a tendency to look at problems in pieces rather than in the aggregate.
Based on the economic model of irrationality and the belief that investors do not always rationally trade off risk and return, researchers introduced a field of study
called “behavioral finance” to analyze investors’ behaviors. The investors sometimes behave in a way that consistent with the rational models but sometimes their actions are influenced by distinctive perceptions and emotional impulses. These rational and irrational behaviors are commonly observed in a capital market and are widely discussed in behavioral finance literatures. Since underwriting risks in the insurance industry are partially a product of insurers’ behaviors, we thus relate the theory of behavioral finance with the insurers’ underwriting conducts.
Underwriting cycle is a phenomenon that is partly driven by insurers’ psyche.
During the soft markets, insurers plunge into the low premium rate despite their reckoning that profit is not quite there. The unprofitable periods often persist until the most rational insurers exhaust their patience or when insurers are no longer able to survive with such low prices. Thus the hard markets arrive.
We can view the cycle in a way that insurers overestimate insured risks some time and underestimate part of the time but do not overestimate or underestimate all of the time. Edward Miller (1977) reports that the difference in behavior depends on the amount of gain. Investors prefer the occasional large gains to the consistent small winnings. His findings can apply to the low price phenomenon in the insurance market. Insurers gamble by bearing loss during the soft market with the hope to gain large profit when the market turns to hard period. Large profits that they could gain in the future encourage them to gamble and face the underwriting loss in the soft market.
Another reason for usual under-pricing in the soft market is that charging relatively high price will cost them the market share. Mental accounting and fear of losing their customers and revenue persuade them to concentrate on the market share rather than overall risks to the company. The loss-aversion regarding the market share leads insurers to take risks by adhering to unprofitable prices in the fond hope that
some day the market will recover and make them whole. The focus on revenue can blind them from realizing the effect from the underwriting risk on other risks that could aggravate the risks of company as a whole. Besides, Shefrin and Statman (2000) report that the human psyche is split into short-term and long-term perspective.
Peoples’ response is a consequence of weights assigned on future and immediate gratification. Since insurers, especially stock insurers, face the compulsive revenue and market share competition, they tend to appreciate satisfaction today more than the long-term value.
In the context of overconfidence, experience, expertise, and learning do not eliminate biases from rational decision making. People tend to overestimate their intelligence and experience while believing that they usually display rationality.
Daniel, Hirshleifer, and Subrahmanyam (1998) proposed a theory of securities market under- and overreactions based on investor overconfidence about the precision of private information; and biased self-attribution11. Their empirical results indicate that overconfident investors overweigh the private information relative to the public signals, resulting in overreaction to the stock price.
The errors in pricing and reserving can be partly a result of overconfidence. If an insurer begins with unbiased estimate of insured risk, new public information about the risk on average is considered as vindicating its private information. The insurer then updates the confidence in her ability in a biased manner. In particular, it would earn more confidence in the private signal to which she overreacts in the future. The overconfidence will continue until new public information (market price) invalidates the private information and the insurer gradually agrees with the
11 According to attribution theory (Bem (1965)), people overweight events that vindicate their judgments and blame the events that disapprove their judgments on external noise or sabotage. Self- attribution bias occurs when people attribute successful outcomes to their own skill but blame
fundamentals. Thus, biased self-attribution implies short-run overconfidence that causes a lag response to the fundamental prices and extends the period of soft or hard markets. In contrary, the reversal of reaction will arrive in long-term and the insurer adjusts insurance price according to the realization of true risks.
In conclusion, behavioral finance fields of study apply psychology to better understand economic decisions. It helps analyze the underwriting cycle phenomenon in respect to rationality or lack of rationality in insurers’ response to market prices.
The principle increasingly becomes the theoretical basis for the underwriting cycle and provides an explanation for the market behaviors that had been mysterious to researchers.
CHAPTER 4