People are punting on insurance – we have to stop them
Insurance is meant to indemnify – which means it is meant to make good a gap, but not create an advantage to the insured if they are paid out.
Thursday, August 19th 2021, 11:12AM 
3 Comments
by Russell Hutchinson
When a financial advantage could occur, there is moral hazard.
Some people fall foul of moral hazard. Although it is generally against my principles to get involved in other people’s moral behaviour, sometimes the hazard affects vulnerable people (children and people bullied by their partner are two common examples).
Milton Jennings used to tell a story about a client who was ‘betting’ that he would make money out of his life cover. The client would call up each year as they became elderly to find out what the premium was going to be.
Perhaps there was an increasing concern that they would not die ‘soon enough’ to ‘make on the deal’.
That situation was merely strange – a product of a client who thought that insurance was about ‘saving up’ for a claim, perhaps.
In short, if a person plans to either play Lotto or buy insurance until they “win”, (in the latter case, die or otherwise have something horrible happen that triggers the insurance), then the expectation of that person should be that they will end poorer than they started.
Some people will end up better off due to luck (as lucky as an early death gets), but the mass of probability sits on insurance costing them more than it will make.
While this should be obvious, I have seen some clients convinced that it will be otherwise, sometimes abetted by their adviser.
For an ordinary person insuring their mortgage is fine. They didn’t expect to make money from insurance, and they don’t intend to keep the insurance until they die – they plan to leave the casino at a pre-defined point as they repay debt and build wealth in more predictable ways.
It’s a point they have probably decided they can afford.
Insurance is not a path to wealth, it’s a contingency. It’s a hedge against another bet they are running with the Grim Reaper.
The maths of the expected outcome for a person insuring a sum to cover their mortgage for 10 years and the person buying insurance for 10 years in the hope it creates a legacy is the same, but the psychology is different, and the psychology is a big part of the utility of insurance.
At the very least, the person who has insured their mortgage until paid has a sense that they have received what they paid for. The person aiming for a legacy is left with nothing, trapped by the gambler’s fallacy – they just need to gamble a little bit more until their luck changes and they get up on the house.
Some people do this with trauma cover. We have laws to prevent people so desperate that they consider doing this with their children.
People don’t have an intuitive understanding of statistics and probabilities. We need to deploy a deep sense of empathy and dissuade them from these misguided attempts at enrichment.
It is good advice to point their efforts in different directions.
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Comments from our readers
Those of us that do Needs Analysis dont find this an issue at all.
Many sales people approach this with how large can we make the numbers, and that's where this disconnects.
I'm constantly amazed with my conversations with underwriters where they have imposed onerous requirements on the client due to the rule book, not because we are asking for a lot of cover but because advisers at large have an approach of prescribing seriously large sums with questionable justification. And a typical Auckland mortgage with future instability now triggers these questions...
I’ve talked about this elsewhere on the site, as this is where our traditional WOL approach of square peg round hole advice continues to be a problem.
However, I recently went through the senario described with a client. Business shareholder cover in place was no longer needed, but they had debt.
The discussion of using the existing cover as a “bet” against the house was the discussion. The exercise was if we converted this to level premium, was there an advantage that could be extracted for the company for debt reduction benefit over a more traditional repayment approach.
Yes, there was, until about age 80-85, after that the approach had diminishing returns against paying down the debt directly or taking a long term investment approach.
The point is the cover wasn’t required any more and we specifically discussed an approach that was a moral hazard for the insurer if they were underwriting this. Yes, there was a justified risk with the debt, but the conversation could have just as easily been without the debt issue as the cover was existing.
We explore these options because they exist, the insurer has to underwrite on the basis of the moral hazard being considered, and the product and salespeople drive the throw it at the wall in between.
Underwriting is the gatekeeper for the insurer, and they have a significant responsibility across the industry.
And many people in our communities have the view that they should get something back from their insurance, so they seek these kinds of things. Cashback life covers in the past being an example catering to this market.
Our role as advisers is to get that balance right, and I don’t think all, of us do.
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