People are punting on insurance – we have to stop them
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.