Consumer behaviour and the GFC

For example, many people on learning about the poor performance of their superannuation policies following the GFC may be tempted to opt for "safe" superannuation policies, such as cash or "capital stable" portfolios, particularly if they have experienced negative returns.

Yet these products are unlikely to do any better than inflation, once fees and commissions are taken into account. Over 40 years of contributing to superannuation, the cost of choosing a "safe" low-yield portfolio can be enormous; it can be the difference between a comfortable retirement lifestyle and dependence on the age pension. (One can see the effects of different fees and returns by use of a spreadsheet model developed for this purpose.)

The other area where financial conservatism can be misplaced is insurance.

The Victorian bushfires in 2009 and the more widespread flooding this year have brought to our attention problems in insurance – definitional issues around what constitutes "flood" damage, and the plight of those who have been entirely uninsured.

The problem of under-insurance is more complex than it appears at first sight, for behavioral research indicates that it is quite normal for people to be both under-insured and over-insured at the same time.

Behavioural research gives some insight into this contradictory situation. We tend to compartmentalize our perceptions of risks, and rarely take into account our whole financial situation. By mid 2010, Australian households held about $900 billion in financial assets – deposits and shares – not including superannuation. That's almost $100 000 a household of reasonably available funds to cover contingencies – minor household repairs, write-off of an automobile with a low book value, minor burglary and other misfortunes.

That's an average figure, and most households have much lower levels of liquidity, but we should reasonably expect that the better off people are financially, the more they would self-insure, for insurance is expensive. That is, we would expect people to use their own savings to cover minor contingencies. Of what we pay in general insurance – house, contents and motor vehicles – only 70 cents in the dollar comes back in the form of settled claims; the rest is accounted for by profits, administrative costs and re-insurance premiums paid by insurance firms.

Yet, research shows that self-insurance is unusual. The higher our income, the more likely we are to pay insurance companies to cover our risks, and the more likely we are to buy expensive policies with zero or very low deductible amounts. Justin Sydnor, of Case Western University, calls this "sweating the small stuff", and he points out that we pay very dearly for such over-insurance. It's not only the very well-off who buy such policies; people of more modest means buy insurance to cover such low-cost events as electric motor fusion, and even to cover funeral expenses – perhaps the only misfortune with 100 percent certainty.

At the same time as we take unnecessary insurance for minor contingencies, we are likely to leave ourselves entirely uncovered for other more serious events. Behavioral research shows that we are very poor at understanding the nature of risk, and that we consider risks in isolation. For example, most of us will know of people who are obsessive, say, about bacterial cleanliness, but who subject themselves to high risk through careless driving or poor diet.

Such compartmentalization is normal, if irrational, behaviour. It explains, for example, why we may try to cover ourselves completely against the cost of an automobile accident, even though the zero-deductible policy is very expensive, while leaving our house comparatively uninsured.

In fact, there are no insurance policies on the market that offer significant risk-sharing for consumers. For example, the highest deductible offered by most firms on domestic buildings is only $1000. Even Choice, the supposed source of sound consumer advice, advocates that people should not take out policies with high deductibles, because if they do "it will rarely be worth making a claim for minor damage". We have built for ourselves a culture of expensive over-insurance, displacing any notion of prudent self-reliance.

Now one would think it would make good sense for insurers to offer risk-sharing products. Imagine, say, a house policy in which the insured person had an excess of $100 000. It should be possible for insurers to offer such policies at a low price, for they would avoid the administrative costs of small claims, and they would have a strong assurance that the policy holder has a high stake in looking after the property - low "moral hazard" in insurers' terms. And, of course, for those who find insurance expensive, the pain of having to find $100 000 in the event of a catastrophe is far less than the pain of being completely uncovered.