Hurricane season will hit the Atlantic coastal region shortly. It’s always a scary time of year for the residents there. Obviously, those who live with hurricane risk as a matter of routine need to be concerned with maintaining their property carefully and obtaining the appropriate insurance.
However, when people calculate their risk of hurricane damage and make decisions about hurricane insurance, they consistently misread their prior experience and make poor choices. This conclusion comes from a paper by Wharton professor Robert Meyer that reports on a research simulation in which participants were instructed that they were owners of properties in a hurricane-prone coastal area and were given monetary incentives to make smart choices about when and whether to buy insurance against hurricane losses, and about how much insurance to buy.
Over the course of the study (three simulated hurricane “seasons”) participants would periodically watch a map that showed whether a hurricane was building as well as its strength and course. Until virtually the last second before the storm was shown to reach landfall, the participants could purchase partial insurance ($100 per 10% of protection, up to 50% total) or full coverage ($2,500) on the $50,000 home they were said to own. Participants were advised how much damage each storm was likely to cause and, afterward, the financial consequences of their choices. They had an unlimited budget to buy insurance.
The focus of the research was to determine whether there are “inherent limits to our ability to learn from experience about the value of protection against low-probability, high-consequence, events.” Sadly, we don’t deal with this type of risk management very well. Our experience helps us somewhat, at least temporarily, but we typically misread that experience.
The bottom line is that participants seriously under-protected their homes. The first year, they sustained losses almost three times higher than if they had bought protection most effectively and rationally. A small portion of these losses were the result of over-insuring. But the key problem was a consistent failure to buy protection or enough protection even when serious and imminent risk was obvious. Moreover, most people reduced the amount of protection they bought whenever they endured no damage in the previous round, even if that lack of damage was specifically the result of having bought insurance.
Experience helped a little. Participants got better at the game as season one progressed, but they slipped back into old habits when season two began. By season three, these simulated homeowners were still suffering about twice as much damage as they should have. As Meyer’s paper reports, these research results are consistent with patterns seen in actual practice. For example, the year after Hurricane Katrina there was a 53% increase in new flood-insurance policies issued nationally. But within two years, cancellations had brought the coverage levels back down to pre-Katrina levels.
These findings should give us all pause. They have significant implications for insurance of various types—whether hurricane insurance, other hazard insurance, life insurance or even portfolio insurance (either via the purchase of options or by “taking risk off the table”). These findings may also offer some insight into the “annuity puzzle” (economists have long been baffled that people buy guaranteed income annuities far less often than reason suggests they should).
We don’t do a very good job dealing with low-probability, high-impact events, whether hurricanes, early death, sequence risk or market bubbles. We are consistently overconfident and, due to the bias blind spot, think these inherent problems may exist generally, but don’t pertain to us.
Critics of our industry (often with good reason) frequently remind consumers that financial products are typically “sold” rather than “bought” and implore them not to fall into that trap. The concept here is that financial products are “sold”—pushed upon a consuming public that doesn’t understand them, want them or need them. Instead, the alleged basis for their continued vibrancy and ongoing sales is that advisors get paid big bucks to sell them.
As should be obvious, it is imperative for consumers to remember the interests of the advisors they are working with and—carefully!—to check their work and analysis. Many tend to think of the sales process as about convincing or even pressuring a mark into buying what they don’t want or need. Too often it is that. Far too many advisors do not look out for their clients’ best interests and all of them have an interest in gathering and gaining new clients. But the idea that because people don’t naturally flock to buy something on their own means that it’s dangerous and bad simply doesn’t hold up, as the hurricane study makes clear.
What is “good for you” and things that have enduring and intrinsic value are sometimes a tough sell. But they are still good and good for you. On the other hand, we often crave what’s bad for us. Parents have a tough time selling healthy food to their kids (and a tough time following their own advice). Local symphonies are struggling to stay afloat while Justin Beiber could support several many times over. And porn is a multi-billion dollar business. Sometimes the stuff we want would be better avoided and the really good stuff (like appropriate hurricane insurance) needs to be sold.
This doesn’t mean, of course, that businesses should not listen to their customers or that advisors should not listen to their clients. In the financial world, not listening to clients is a huge problem. Too much financial “advice” is about pitching what the salesman wants to sell rather than listening for and to a client’s dreams, aspirations, goals, circumstances and problems and then going about creating a way to get where they want and need to go. Sometimes that advice won’t be what the client wants to hear. Sometimes it will include an approach that the client had never considered. Sometimes it will need to be sold.
I was recently talking with an advisor about a client couple’s retirement planning in light of a recent inheritance. The wife had squandered a fortune many years ago and didn’t want to make the same mistake twice. But she and her husband were looking to live a lifestyle in excess of their means by tapping the bequest right away as well as going forward and the husband was looking to retire very early too.
The advisor could have offered a portfolio “solution” that would have given these clients what they said they wanted. Since the immediate spending goal expressed was not wildly above their joint income level, that solution might even have succeeded. It surely would have been an easy sale.
But it wasn’t the right advice. The right advice was suggesting they temper their spending, live within their means, save more and not retire too early. Since the right advice was not what the clients wanted, it needed to be sold.
Ultimately, a financial advisor’s job is to provide clients what they need—not just what they want. There are plenty of “advisors” who will give their clients what they want. Sometimes doing what’s best for them—providing them with what they truly need—takes a great sales job. And that’s not a bad thing at all.
Bob Seawright is chief investment and information officer for Madison Avenue Securities in San Diego.