Overconfidence and Optimism Biases in Insurance Purchasing Decisions and Overcoming Them Through Nudge

Overconfidence and Optimism Biases in Insurance Purchasing Decisions and Overcoming Them Through Nudge

DOI: 10.4018/979-8-3693-1766-2.ch009
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The expectancy theory developed in behavioral finance has led to a significant paradigm shift by incorporating cognitive factors into the financial decision-making process. Deviating from the traditional finance approach, which assumes individuals act entirely rationally in their financial decisions, behavioral finance focuses on cognitive biases within the scope of its examination. A portion of studies in behavioral finance centers on various cognitive biases that guide investor behavior in decision-making processes. In the study, starting from assertion that cognitive biases play a determining role in individuals' financial behaviors, the impact of overconfidence and optimism biases on insurance purchasing behavior is examined from a behavioral finance perspective. Practices that could ameliorate the effects of overconfidence and optimism biases on insurance purchasing decisions are analyzed within Thaler and Sunstein's Nudge theory. Based on this analysis, recommendations for implementing measures to mitigate the impact of the biases on insurance purchase decisions are provided.
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The widespread academic acceptance of Behavioral Finance is attributed to the seminal work of Kahneman and Tversky (1979). Undertaking psychological studies with the aim of scrutinizing rationality, they subsequently formulated a new theory termed 'Prospect Theory' (Bachmann, De Giorgi, & Hens, 2018). Kahneman & Tversky have served as a catalyst for a new generation of research employing insights from cognitive psychology to enhance financial and economic models. Prospect Theory, as an alternative to conventional financial models, furnishes a more robust explanation for observed human behaviors (Pompian, 2012). The theory underscores a nuanced framework, delineating a complex interplay of various biases aimed at comprehending investor behavior. The research conducted by Kahneman & Tversky (1979) has discerned that investors' decision-making processes encompass an array of cognitive biases that influence their behavior (De Bondt & Thaler, 1985; Chang, 2011). Furthermore, their findings indicate a systematic deviation in decisions made under conditions of uncertainty from the predictions of traditional economic theory. In this context, the Prospect Theory put forth by Kahneman and Tversky (1979) has engendered a paradigm shift by integrating diverse cognitive factors into the decision-making process, imparting a distinct dimension to individuals' financial decision-making. Cognitive biases, generally arising from perceptual errors in the storage, correction, and processing of information or in the formulation of decision problems (Hilbert, 2012) have become a focal point, underscoring the increasing significance of endeavors to rectify the deleterious impacts of cognitive biases on the decision-making process.

Within the academic discourse concerning the insurance sector, numerous cognitive bias studies predominantly center on the adverse effects of overconfidence on insurance purchasing behavior (Bregu, 2022; Huang & Luo, 2015; Sandroni & Squintani, 2004). Furthermore, studies exist in the literature that contextualize the “overconfidence” bias within the realm of the “optimism” bias (Coats & Bajtelsmit, 2021; Sandroni & Squintani, 2007). Consequently, this paper scrutinizes the interplay between behavioral finance and insurance, deliberating on the impact of overconfidence and optimism biases on insurance purchasing behavior. Subsequently, practical interventions to ameliorate the influence of overconfidence and optimism biases in insurance purchasing decisions are examined within the framework of Thaler & Sunstein (2008) “Nudge” theory.

Thaler & Sunstein's (2008) book, “Nudge: Improving Decisions About Health, Wealth, and Happiness,” is grounded in the assertion that individuals need to be nudged toward decisions that will enhance their lives, making them more prosperous, healthier, and more liberating. In this study, the application of choice architecture in the field of behavioral finance is explored. The “Nudge” theory, developed based on the theoretical framework of behavioral finance, aims to address human irrational behavior and cognitive biases. Nudging can be defined as a choice architecture that guides individuals' behavior to predict their choices without prohibiting options or significantly altering existing economic incentives. Choice architecture refers to the structure involving individuals or institutions that organize the subjects or issues individuals need to make decisions about (Thaler & Sunstein, 2008).

Key Terms in this Chapter

Structure Complex Choices: Structuring complex choices as a nudge strategy involves simplifying decision-making processes by breaking them down into smaller, more manageable steps or by providing clear guidance and information ( Thaler & Sunstein, 2008 ).

Choice Architecture: Choice architecture refers to individuals or institutions organizing issues or topics people must decide about ( Thaler & Sunstein, 2008 ).

Default Rules: Default rules, as a nudge strategy, refer to setting a particular option as the default choice in a decision-making process. This strategy leverages the tendency for people to stick with the default option, often resulting in higher compliance rates ( Thaler & Sunstein, 2008 ).

Behavioral Finance: Behavioral finance is described as an interdisciplinary research field combining insights from psychology and finance to understand better investors' behaviors and their approaches to investment instruments ( Bachmann, De Giorgi, & Hens, 2018 ).

Nudge Theory: Nudging is a choice architecture that predicts individual behaviors by guiding options without banning them or significantly changing existing economic incentives ( Thaler & Sunstein, 2008 ).

Optimism Bias: Optimism bias is the tendency to overestimate the likelihood of positive future outcomes and underestimate the likelihood of adverse future outcomes ( Weinstein, 1980 ).

Overconfidence Bias: Overconfidence in oneself denotes the inclination of an individual to exaggerate their abilities, expectations of success, positive outcomes of events, or the accuracy of their knowledge. This tendency arises from individuals being unaware of the limits of their cognitive capacities ( Conger & Wolstein, 2004 )

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