Behavioural finance in credit insurance
Daina Muceniece, Trade Credit Underwriter,
Sompo Canopius (‘Canopius’)
With trade credit market becoming more and more competitive, each broker and insurer is trying to find a way to improve their offering and reduce their claims. And when we think of increasing speed, efficiency and overall customer experience we immediately turn our focus to technology. We rush to improve our customer portal, provide instant pricing and risk decisions online, find clever ways to collect more and more data and so on. All of these are fantastic developments in trade credit market and I am a big supporter of such technological innovations. However in all the excitement over innovation we have put technology before people. But focus on people and, more specifically, human behaviour can help us to make the most effective business decisions and therefore reach our business targets.
I believe our focus has switched to technology because technology is a lot easier to understand and comprehend than people. But we forget that our business theories and models are built with a key assumption that our clients, brokers and insurers will make rational decisions at all times and even when put under pressure. However, behavioural finance has shown that we are very far from rational. Therefore no pricing model, loss projection or probability of default will ever be 100% correct (or most of the time not even 50% correct), because human element always plays a role and because human decisions are not always rational.
That is why it is possible for one client to have a major loss while the other has no claim at all given identical industry, buyer portfolio and trade credit policy. Because we are not always rational, my vet is able to sell ear drops with the same ingredients but different packaging for both £7 and £15. Sometimes we just prefer to buy a more expensive item making ourselves believe that it’s better quality (anchoring bias), or other times we keep believing that our buyer will pay off the overdue despite a number of failed rescheduling plans (optimism bias).
Behavioural finance or behavioural economics combines three fields of science – neuroscience, psychology and economics/finance. It aims to understand how people make decisions, what affects their decision making and how to adapt or modify behaviours to achieve the most efficient results for ourselves and our clients. (Note that reference to client can mean broker, insurer or insured depending on your standpoint.)
Whether you are an insurer, broker or insured behavioural finance can help you and your clients to make more effective decisions. As a broker you can apply behavioural finance to better understand your client and insurers. For example, if your client has illusion of control bias then they are likely to underestimate their previous losses and more tempted to become self-insured. In this instance, correct the bias by clearly outlining loss history and recommending a clear log of decisions, overdues and losses for future records. This client may have significant overdues on their balance sheet but be refusing to accept the loss (sunk-cost fallacy).
As an insured, you can benefit by reviewing biases in your sales, collection and credit management teams. Recognising, understanding and mitigating biases in your team will lead to more effective, consistent long term performance.
Framing bias is very common and people often try to use it in their advantage. Framing bias presents itself when we process information in different ways depending on how it is presented and therefore make different business decisions. For example, are you more likely to support a client that has 60% success rate or 40% loss rate? If you or your client shows signs of framing bias, then try to remove facts from the context and view them in an unbiased form.
As Excess of Loss (XoL) insurers, understanding our clients is a key part of what we do. We provide s significant level of authority to our client to make their own decisions, thus putting control in our client’s hands. XoL policies also provide non-cancellable limits, which means that again credit management control is left to our client. The only way that we can effectively manage such product is by trusting our client. And the only way to trust our client is to understand their goals, their way of thinking, their business DNA. That means we need to understand their biases, because they affect the way the sales person, the collection agent, credit manager and CFO will interpret information, and therefore how they make decisions. That is how we can continue to support a client in a declining industry despite cover being reduced in the market, or the reason why we may offer a troubled buyer for one insured and not the other, or why we may not increase a deductible after a bad underwriting year. But in order to know your client it is not sufficient to read their credit management procedures and bios on directors. Insurers and brokers have to spend more time with their clients and prospective clients.
When we take the time to understand our own and the biases of others, the door to enormous potential is open. It can lead us to more effective and successful business decisions and long term trusting and supporting customer relationships.