With the very recent publishing of yet another list of the worst bad faith insurers, this time by the American Association for Justice, the topic of why the public holds these companies in such low esteem again becomes topical.
We’ve well chronicled the dirty tricks and underhanded tactics these socially deviant companies employ to satisfy their relentless thirst for profit but that is not the thrust of this post. Rather, in keeping with today’s theme of “the why” as Nowdy linked my comment on the Yahoo Allstate message board in her Daily slab post I’m expanding on the concepts from that post and in the process explain one of the possible reasons why an insurer with a good reputation in Chubb will be inherently more profitable than one with a bad reputation in Allstate.
When I first met Nowdy and we began to get to know each other I told her my favorite hobby was investing and to that end, the fields of Game Theory and Behavioral Finance were of great interest to me along with their political first cousin Public Choice theory, the latter two economic disiplines being relative newcomers to our body of collective knowledge.
After 20 months of writing here at slabbed I finally get to indulge those passions and perhaps educate our readers on the mechanisms at work that resulted in what became known here on Slabbed as The Scheme, a series of posts by Nowdy that explained the bad behavior of the insurers here after Katrina. In short not only do we tell you who dunnit but also how it could happen in a large organization like State Farm, Nationwide, USAA, Allstate and others. We start with the July-August edition of the Harvard Business Review and Dan Ariely’s article The End of Rational Economics:
In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the U.S. Federal Reserve once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”
We are now paying a terrible price for our unblinking faith in the power of the invisible hand. We’re painfully blinking awake to the falsity of standard economic theory—that human beings are capable of always making rational decisions and that markets and institutions, in the aggregate, are healthily self-regulating. If assumptions about the way things are supposed to work have failed us in the hyperrational world of Wall Street, what damage have they done in other institutions and organizations that are also made up of fallible, less-than-logical people? And where do corporate managers, schooled in rational assumptions but who run messy, often unpredictable businesses, go from here?
We are finally beginning to understand that irrationality is the real invisible hand that drives human decision making. It’s been a painful lesson, but the silver lining may be that companies now see how important it is to safeguard against bad assumptions. Armed with the knowledge that human beings are motivated by cognitive biases of which they are largely unaware (a true invisible hand if there ever was one), businesses can start to better defend against foolishness and waste.
The emerging field of behavioral economics offers a radically different view of how people and organizations operate…
Drawing on aspects of both psychology and economics, the operating assumption of behavioral economics is that cognitive biases often prevent people from making rational decisions, despite their best efforts. (If humans were comic book characters, we’d be more closely related to Homer Simpson than to Superman.) Behavioral economics eschews the broad tenets of standard economics, long taught as guiding principles in business schools, and examines the real decisions people make—how much to spend on a cup of coffee, whether or not to save for retirement, deciding whether to cheat and by how much, whether to make healthy choices in diet or sex, and so on. For example, in one study where people were offered a choice of a fancy Lindt truffle for 15 cents and a Hershey’s kiss for a penny, a large majority (73%) chose the truffle. But when we offered the same chocolates for one penny less each—the truffle for 14 cents and the kiss for nothing—only 31% of participants selected it. The word “free,” we discovered, is an immensely strong lure, one that can even turn us away from a better deal and toward the “free” one.
Dan Ariely goes on to explain in detail why people cheat, and why the problem becomes worse in a group environment. As I read his article I thought of State Farm claims manager Lecky King and the gyrations she must have gone through to rationalize her behavior here after Katrina. It was easier for King however since she was part of a group of claims professional that collectively give State Farm its well deserved bad reputation for fleecing its customers. The outliers of course are the Rigsby sisters who managed to acheive a rare degree of self awareness despite the large sums of money they made adjusting claims.
So why do we lie, cheat and steal? Evidently because we’re hard wired to occasionally cross the line as we continue with Professor Ariely’s article:
In a series of three experiments, we gave participants 20 math problems to solve in five minutes and paid them 50 cents for each correct answer. In our first treatment (the control condition), individual participants were asked to write the number of problems they answered correctly on collection slips and give them to an experimenter, who checked the totals against the problem sheets. In a second treatment, participants shredded their answer sheets without verification and simply submitted their collection slips to the experimenter. Perhaps not surprisingly, we found these participants lied, saying that they’d correctly answered two more questions, on average, than those in the control treatment.
Things got more interesting in the third treatment, where participants worked in pairs and shared the spoils. The results showed that when a person realizes that his or her fudging would benefit other team members by increasing the payout, dishonesty further increased by 25%.
In another setup, we tried to discover whether monitoring and supervision would counteract team cheating. In fact, it did not. Though cheating decreased somewhat, it didn’t disappear. More disturbingly, as the members of our experimental group became better acquainted, the tendency to cheat for the sake of the team increased even more.
Other experiments revealed that if one person is clearly seen to be cheating, team members—particularly those who feel connected to the cheater—are likely to depart from their own moral compasses and increase their cheating. It seems that cheating is infectious.
These findings have serious implications for unsupervised collaborative work in organizations. Although work groups can have many social and functional advantages, they may also be more vulnerable to unethical conduct.
Here after Katrina the insurers operated and paid National Flood Insurance Program claims with no oversight by FEMA and the results, as the professor points out are predictable. After the fact the GAO did finally figure out the NFIP was set up in a way that had inherent conflicts of interest involving the private insurers.
Meantime Judge Sarah Vance in New Orleans is still waiting for her explaination on why Allstate contract adjuster Mung Hatter grossed up Robert and Merryl Weiss’ NFIP claim with non existent furs and jewerly (without their knowledge) while Allstate’s legal team made the legal argument (aided by a law blogger from Portland whose law firm also represents Allstate) that the fact the Weisses took NFIP proceeds should reduce their wind payout calling it “double dipping”.
Nowdy is the behavioral expert at Slabbed and she has written a good bit about the “defense mechanisms” used by the insurers to conceal their deviant behavior here after Katrina such as blaming their victims. For people like Robert Hartwig, front man for the Insurance Information Institute and a man that I personally think is a sociopath, propagandizing the events here has proven to be a profitable endeavor.
Besides coming to realize the true nature of the problems in places like Northbrook and Bloomington Illinois I also understand the people that run these organizations for their self benefit will never willingly admit to the wrongdoing preferring instead to pay shills like Hartwig to spread misinformation while hiring legions of lawyers to run interference in the court system.
But there is a problem with the strategy employed by bad faith insurers. Spending truck loads of money on lawyers and shills like Hartwig in the aftermath of the bad corporate behavior is expensive and it creates enemies. Simply put there are only so many people who can be fleeced on their claims in this country which means the business model is not sustainable. Beyond that Professor Ariely expands on the consequents of bad behavior with the concept of revenge.
In his October 2008 Psychology Today article, Why People are Against the Bailout, Dan Ariely explains the implications of a 2004 Swiss study on the topic:
Consider a study conducted by group of Swiss researchers led by Ernst Fehr (and by the way don’t you think it’s ironic that the Swiss are the ones doing research on revenge?) who examined revenge using a game we call The Trust Game. Here is how it is set-up: You are paired up with an anonymous participant. You are kept in separate rooms and you will never know each other’s identity.
The experimenter gives each of you $10. You get to make the first move. You must decide whether to send your money over to your partner, or to keep it. If you keep it, both of you get your $10 and the game is over. However, if you send him the money, the experimenters quadruple the amount and add it to the $10 so that the other player has his original $10 plus $40 (10 multiplied by four). The other player then decides whether to keep all the money, which means that they would get $50 and you would get nothing or they could send half of it back to you, which means you would have $25 each.
This is the basic trust game and the question, of course, is whether you and people like you will trust the other person and send them the money- potentially sacrificing your financial well being-and whether the other person will justify the trust and share their earnings with you.
But the Swiss version of this game did not end there. If you sent your money to the other player and if he or she did not send the money back, you would now have the opportunity to punish the bastard. You could spend money to make them suffer. In fact, for each dollar that you spend, they would lose $2. What do you think, if you were playing the game and the other person betrayed your trust, would you choose this costly revenge? Would you sacrifice your own money to cause them to suffer? The experiment showed that many people punished and they punished severely, yet this was not the most interesting part of the study.
Indeed it is and I hope this next part is not lost on our very good friend Sup, who regularily ties it up with another poster Olderagent on Yahoo Allstate. I was lucky enough to see Olderagent on the national news explaining what former CEO Ed Liddy did to Allstate agents back in the 1990’s while he was preaching contract sanctity rationalizing those obscene bonuses paid to AIG Financial Product employees earlier this year. Far from bitter, I rather suspect each wound Olderagent inflicted on Mr Liddy brought a certain amount of self satisfaction as we continue:
What I didn’t tell you was that while the participants were making their decisions, their brains were being scanned by Positron Emission Tomography (PET). So the experimenters could observe participants’ brain activation while they made these decisions and were able to see what parts of the brain correlated with their desire to punish. The basic picture that emerged from the brain imaging was activation in the striatum, which is somewhat surprising as this is a key part of the way we experience reward.
In other words, according to the brain activation it looks like punishing others or, more specifically, the decision to punish others is related to a feeling of pleasure in the brain. What’s more, it turns out that those who had a high level of striatum activation, punished others to a higher degree. All of this suggests that punishment, even when it costs us something, has biological underpinnings. And this behavior is, in fact, either pleasurable or somewhat similar to pleasure.
I don’t know exactly how to quantify how the concept of revenge plays out to the bottom line of these insurers quite yet but somehow I suspect it is part of the explanation why the loss ratio of a bad faith insurer in Allstate well exceeded that of Chubb, which enjoys an excellent reputation in how it handles claims.
For those who are interested (and despite the fact I bought Professor Ariel’s excellent HBR article) the entire piece is available here for free and is well worth the read. In researching this post I also watched the Professor on the PBS Newshour and this HBR blog. Somehow I think Nassim Taleb would appreciate the Professor’s research. I hope our readers find this post informative.
JUSTICE PIERCE: So you’re sequencing, if 95 percent of the home was destroyed (by wind), and then we have the event of the storm surge, then you would not pay a dime?
MR. LANDAU: Your Honor, if we prove that the storm surge was sufficient to cause – we have that burden, again, and that is absolutely crystal clear.
If we can prove that the storm surge was sufficient to cause all of this, it is no answer then to say, ‘Yeah, but I’m going to show it — I’m going to have somebody come in and say, “Look, guess what, the window was broken before the storm surge came and then wiped away the whole house.
But you don’t get into those kinds of issues precisely because of the sequencing of the damage.
JUSTICE PIERCE: So you wouldn’t pay a dime?
MR. LANDAU: If – again, we wouldn’t pay a dime for things where we can carry our burden, which is right there in the policy, of showing that the loss was caused concurrently –
JUSTICE PIERCE: I’m giving you — the example is 95 percent of the home is destroyed, the flood comes in and gets the other five percent, and you know that.
Does your interpretation of the word “sequence” mean you pay zero?
MR. LANDAU: Yes, your Honor.