By Amanda Hug with insights from Michael Wong
After a stimulating lesson on the psychology of mental accounting and sunk costs, professor Richard Thaler opened the floor for questions. Mine came from personal experience: “Okay, humans overspend when lured with low prices. So what advice would you give to someone who loves shopping sales?” Dr. Thaler smiled knowingly and effortlessly discredited my years of bargain shopping. “Stop caring about deals! You’d be better off paying full price for everything. With sales, your savings are wiped out by the extra money you spend on things you wouldn’t have otherwise bought.” Two months later, he would win the 2017 Nobel Memorial Prize in Economic Sciences and become the 79th laureate in his field for his contributions to behavioral economics.
Humans & Econs
Thaler’s life work has centered on the psychology of human decision-making as it relates to economics and finance. He challenges the conventional economic assumption that humans act rationally and in their best interests. In his global best seller, Nudge (2008, co-authored with Cass R. Sunstein), he coins the terms “Econs” and “Humans.” Econs, Thaler argues, “can think like Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower of Mahatma Gandhi.” But those imaginary types are rare, and the much more common Humans have trouble dividing without the help of a calculator, sometimes forget their spouse’s birthday, and yes, buy too much on Black Friday. Humans are predictably irrational, Thaler insists, and as such can be influenced, or nudged, to make good decisions.
Since 1995, Thaler has been a professor at University of Chicago’s Booth School of Business, where I am currently pursuing my MBA. I recently had the privilege of taking his Managerial Decision Making class, in which Dr. Thaler regaled us with stories about his research on human behavior over the last five decades. His lectures were eye-opening and focused on practical applications for using behavioral economics to nudge our customers, colleagues and even significant others, for good.
Save More Tomorrow
Thaler’s research and impact goes well beyond academic walls. His work promoting auto enrollment and originating auto escalation in 401(k) plans is considered to be one of his most significant contributions to modern day society. Together with Shlomo Bernartzi, Thaler created the trademark concept called “Save More Tomorrow,” or “SMarT,” which is now known in the retirement industry as auto escalation. In their 2004 article, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” they argue that many households have good intentions of saving but struggle with self control and procrastination. These families might just need an extra nudge to get there. The SMarT design uses four building blocks to stimulate better retirement planning:
- Approach employees well in advance of a pay raise about increasing their contribution rates.
- Increase contribution rates in the first paycheck after a pay raise to avoid a loss in take-home pay.
- Increase contribution rates with each raise until reaching a preset maximum.
- Allow opt out at any time.
This design takes advantage of inertia and status quo bias to position plan participants well for retirement. In Thaler and Bernartzi’s sample study, after four pay raises, the average contribution rate was 13.6 percent for SMarT participants as compared to 5.9 percent for those who declined the SMarT plan.
In 1998, in part due to Thaler’s urging, the IRS published Revenue Ruling 98-30, which discusses the tax implications of auto enrollment. The ruling refers to a three percent automatic contribution rate. While three percent was simply meant to be an illustrative rate, and is actually quite low, it prompted thousands of employers to set their default rate at three percent. During one of our class sessions, Thaler bemoaned the fact that they didn’t use a higher sample rate in the ruling!
A 2016 survey by the Plan Sponsor Council of America found that 58 percent of defined contribution plans implemented auto enrollment, up from just 8.1 percent in 2000. Another study by the Defined Contribution Institutional Investment Association reported that half of surveyed plans implemented auto escalation. It is no stretch to say that Thaler’s work has had a tangible and far-reaching impact on the retirement accounts and lives of millions of Americans.
Downing Street and Hollywood
Thaler’s influence is not limited to the United States. In the United Kingdom, he helped establish the Behavioral Insights Team (BIT) at 10 Downing Street in 2010. The world’s first government institution dedicated to the application of behavioral science, and more affectionately known as the “Nudge Unit,” BIT seeks to make public services more user friendly, improve policy outcomes, and enable citizens to make better choices. Thaler sits on their Academic Advisory Panel and consults on the team’s work.
A successful career in behavioral science led Thaler to the big screen, where he debuted his acting skills alongside Selena Gomez in the 2015 film, “The Big Short.” At a poker table, he delivers a tutorial about the drivers of the 2008 global financial crisis. In class, Dr. Thaler recalled his foray into Hollywood fondly, remembering that he even had to improvise part of the scene when he realized the explanation for the crisis written into the script was flawed.
It wasn’t his big screen appearance, though, that had my classmates and me lining up at every class break for photos with Dr. Thaler and autographs on our copies of Nudge. It was his transformational work in behavioral economics and passion for the subject that inspired us all. The beauty of behavioral economics is that its application transcends a specific industry and can be applied wherever you can find Humans. While actuaries might like to think we are a bunch of Econs, invulnerable to systematic biases and mistakes, the reality is, we all have a little Human in us. We can learn from Dr. Thaler’s work and the world of behavioral economics to improve our own decision-making. We, actuaries, can also take these lessons into our organizations to develop more client-focused products, improve underwriting methodology, and refine the accuracy of claim cost assumptions. Our profession affords us the unique opportunity to deliver standout business results while simultaneously bettering the lives of our customers, provided we heed Dr. Thaler’s guiding principle: always nudge for good.
Dr. Richard Thaler and Amanda Hug after a class session at University of Chicago Booth School of Business.
A Digital Nudge
A nudge towards a more favorable retirement allocation is only the beginning of Thaler’s influence on the insurance industry. More recently, companies have aligned health wellness incentives to nudge towards a better society. The natural benefit of any good nudge is two-fold: healthier people/more-reliable workers and lower aggregate claims, at least for the more avoidable morbidity situations (we will avoid the discussion of longevity for now). The bottom line is that lifestyle influences can be both monetary and behavioral, and they really do not need to be large incentives to catalyze big changes. The intermediary between the initial nudge and final shift in behavior is a transformation in “mental accounting,” a term Thaler coined regarding behavioral finance allocations. Thaler postulated that people categorize financial decisions into buckets, but these buckets can be totally irrational or outdated! The nudge allows mental accounting to become more malleable, paving the way towards better living and a more adaptable society. With all of this in mind, the entire insurance industry is about to make a breakthrough from its traditional visage. The future looks towards big data, rapid technology growth, and most importantly: automation and analytics. These spearhead the next stage of what we will call, the “Digital Nudge.”
Thaler is a huge proponent of automation, especially when it has a positive impact for the consumer, or Human. Thaler should be proud of the leaps and bounds insurance companies have made to become more customer-centric. Now, we have the data analytics and computing power to take it to the next level. In the world of insurance, automation (and more broadly, Insurtech) has become the innovation mecca. Harnessing technology leads to lower costs, better efficiency, and more importantly, larger growth in untapped or undeveloped markets. Millennials and Xers have been a stubborn industry across all product groups. We should leverage Thaler’s advice of a nudge, in this case, to initiate enrollment and participation. Said differently, a new and more rapid form of communication between insurers and insureds must exist to foster this environment. Technology ideally should enhance ease of accessibility, awareness and purchase. Customer experience, more specifically the digital experience, drastically shapes perspectives in our industry. This front-loaded approach is only now catching on, spurring many companies to re-think branding and product presentation. Customer-centricity is all about providing accessibility with ease and transparency. Gone are the days of the banal insurance. Can we nudge the next generation with these new tools?
Let us dive into the technological interactions. Automation has always been favorable to the actuarial toolbox. The day has arrived when automation touches more than just actuarial models: it can now help streamline underwriting, product navigation, and even the claims process. Automation naturally paves the way for analytics which in turn can improve the agility of the insurance world. These analytics give us a much better understanding of how people view and evaluate our products. Product innovation should flourish in the age of technology, benefiting the consumer who helped (indirectly) design the product in the first place. Together, automation and analytics allows the business to become proactive rather than reactive for our customers. Firms that invest intelligently will soon see the “Digital Nudge” take shape. “In an analog world, an insurer will be unaware when a customer holding a home insurance policy puts that home on the market. In a data-rich digital world, that need not be the case, and the knowledge that a home is up for sale becomes an opportunity to offer new home cover, new auto cover, and perhaps a life product to help cover a mortgage on the new house” states the prestigious consulting firm McKinsey. The takeaway is that the insurance world can create business opportunities that naturally satisfy customer need. To echo previous statements, we believe that a win-win world can emerge from a customer-centric space.
Speaking as one, Millennials like options and transparency; they are generally already aware of the various products. However, their mental accounting, especially for insurance products, suffers from the fallacies shared by other generations. Thankfully, Millennials are very responsive and attuned to technological stimuli. For example, according to a digital insurance study run by McKinsey, “Millennials are more likely to visit websites to explore their options, and then see an agent to get a quote, translating to a completed transaction.” Their emersion with technology has created this environment, leading to the belief that digital personalization pays off. This new facet of the marketing game has spurred the growth of “Insurtech” firms. This notion has rattled the insurance industry, and even given rise to suspicions that big data players like Google could enter the market. Data is king, and open source software is becoming the competitive edge.
So how can traditional insurance giants keep out these potential entrants, big or small, and take control of the future? The answer is already happening: we must incorporate the digital nudge into our daily processes. Our competitive advantage is our actuarial knowledge in product innovation, complex regulation, and more. Large insurers currently have the financial stability most nascent firms are trying to develop. However, as history has proven, new money talks fast, and we must refine our approach. Product complexity will continue to increase but we must bridge the gap between complex mathematics and simple and easy product explanations. Digital technology has led the customer to expect simplicity and a straightforward way to shop. Let us create a new era of understanding for our incoming customers and nudge future generations towards stronger affinity for insurance products and services.
To conclude, there is still time to get ahead of the movement. Digital technology will require a long incubation time to disrupt some business lines, such as life insurance, and it may even disrupt them in unexpected ways. However, given its impact to date across all industries, it would be foolish to oppose it. Let’s take a lesson out of Nobel Prize laureate Richard Thaler’s playbook, and start to use behavioral economics to nudge our companies and customers for good.
Amanda Hug, FSA, MAAA, is an actuary at MassMutual. She holds a bachelor’s degree from Wheaton College (Ill.) and is pursuing her MBA at University of Chicago’s Booth School of Business. She can be contacted at firstname.lastname@example.org.
Mike Wong is an actuarial analyst at MassMutual. He holds a Master’s degree in Economics from New York University (NYU), with additional degrees from The London School of Economics and The University of Massachusetts: Amherst. He can be contacted at email@example.com.
Facing Digital Reality. Tanguy Catlin, Johannes-Tobias Lorenz, Christopher Morrison, and Holger Wilms - https://www.mckinsey.com/industries/financial-services/our-insights/facing-digital-reality. Accessed 11/15/17.