Prospect Theory

Our friend and foe

Full disclosure; I find the behavioral sciences fascinating. And I realise that this fascination isn’t universal, so feel free to stop reading here if you don’t share my geekdom.

Before we dive in, let me offer a quick definition of what prospect theory is (borrowed from here).

Let me try to put this in English. Basically, prospect theory tries to explain how people make a choice between options which involve risk, and where the result of the decision is unknown.

What I find most interesting about prospect theory is that it starts to explain how our cognitive biases can affect our decision making. There are 3 main biases associated with the prospect theory, namely:

• Loss Aversion
• Certainty
• Isolation Effect

Let’s unpack these.

Loss Aversion

The two guys credited with developing the prospect theory, Misters Kahneman and Tversky, described loss aversion as “losses loom larger than gains”.

This kind of poetic prose probably wins you Nobel prizes. In plainer speak, it means that people experience more emotional trauma with a loss, than the joy they’d experience with a gain of the same size. So we react more strongly to moments of loss (or potential loss).

People will tend to behave in a way that minimises loss (and potential loss) because it feels so horrible. And they wouldn’t chase the same-sized potential gains with the same vigour.

Certainty

This one’s fairly simple. People prefer a certain outcome, over the chance of getting something more (with the consequent possibility of getting something less).

For example, if you offered people one of two choices:

Either you can get a guaranteed R700.

OR you have a 70% chance of getting R1,000 and a 30% chance of getting nothing.

In both cases, the expected outcome is exactly the same, R700. But most people would prefer the certainty of the first option, rather than run the risk of getting nothing.

The Isolation Effect

This effect talks about people’s tendency to make decisions based on information that stands out between choices, and disregard elements which are common to the choices. This is a problem because it can lead to inconsistent decisions.

Kahneman and Tversky presented participants with 2 scenarios. In both scenarios, people were given an initial amount of money, and then had to choose between two alternatives.

Scenario 1: Participants started with $1000. They could then choose between:

A. Winning $1000 more with a 50% probability (and winning $0 with a 50% probability), or

B. Getting another $500 for sure.

Scenario 2: Participants started with $2000. They could then choose between:

C. Losing $1000 with a 50% probability (and losing $0 with a 50% probability), or

D. Losing $500 for sure.

Because the initial amounts are different in the two scenarios, it turns out that the two scenarios are actually equivalent: if people chose option B in Scenario 1 or option D in Scenario 2, the amount of money they’d have in the end would be the same ($1500). (Options A and C are likewise equivalent.) However, people made opposite choices in the two scenarios: the majority chose the risk-averse option B in Scenario 1 and the loss-averse option C in Scenario 2. People are weird. (This example is from here).

Why is prospect theory our friend?

We like the prospect theory because it leads to an increased demand for insurance in general.

Because of loss aversion, most people are willing to have a small, certain loss (the premiums you pay for insurance) in place of a potentially catastrophic loss (an insurance claim).

Why is prospect theory our foe?

It’s fairly clear how prospect theory drives overall demand for insurance. However, for Indie, prospect theory is a challenge we need to overcome.

The reason is that Indie, as a new brand and new value proposition, is largely an unknown entity. So assuming that someone has made the decision to buy life insurance, they then have to decide who to buy life insurance from.

And this is where prospect theory can potentially hurt us in the short term. Let’s assume this someone has made the decision to buy insurance, and he has whittled the choice down to two insurers: Big ‘ol insurer and little new Indie.

In fairness to the potential client, Indie is an unknown. While he or she can be fairly confident that Big ‘ol insurer can be trusted to be there and pay the claims when they need them, Indie cannot simply assume that same position.

We’ve built a brilliant value proposition, which we’re confident offers better value than the industry currently delivers; but in a client’s mind, there is the small, sneaky possibility that Indie may deliver nothing. In a rational world, Indie wins hands-down every time, because the expected outcomes from Indie are superior.

But in a world of cognitive biases, we may fall short due to the perception of the possibility of loss in dealing with us.

So what are we doing about it?

Being the small guy means we work harder. We have to fight, tooth and nail, for our place in this world — to build up the credibility of Indie, so that the perception of the possibility of us not delivering on our promises is negligible.

Our messaging and branding need to command attention in the market.

We do also think that the Isolation Effect will work to both our and our clients’ advantages. Sure, at the moment we sell Life Insurance. And this Life Insurance will pay claims as reliably and consistently as the industry big-shots. But we also have some really great distinguishing features, which make Indie special and memorable.

Like the fact that Indie insurance is fully digital — built that way from the ground up. And the way we help you determine which insurance plan is best for you. And we have Bounty, which is fantastic on its own. And most of all, we really care about our clients winning and succeeding with us. These are tangible, distinguishable features which make Indie what is is.

And because people tend to put emphasis on features which stand out, we’re confident that Indie’s stand-out features will help get our prospective clients across the line.