Sunday, November 1, 2015

Buy Term, Whole Life Insurance, or Both? Part 4: Behavioral Limitations to Buy Term & Invest the Difference: Adverse Selection & Mental Accounting in Budgeting

Buy Term, Whole Life Insurance, or Both? Part 4: Behavioral Limitations to Buy Term & Invest the Difference: Adverse Selection & Mental Accounting
Photo: Werner Elmker, Fairfield, Iowa

This is the fourth in a series of articles summarizing a preeminent, recent study examining the intersection of insurance and personal savings.
In “Buy Term and Invest the Difference Revisited,” finance professors David F. Babbel from The Wharton School of the University of Pennsylvania and Oliver D. Hahl from Tepper School of Business, Carnegie Mellon University examine in detail term vs. whole life insurance in a paper published in May of this year in the Journal of Financial Service Professionals[1].

Behavioral Limitations to Buy Term and Invest the Difference

While the Buy Term and Invest the Difference ("BTID") campaign matched the financial “innovation” revolution from the 1960s through the 1990s by attempting to deconstruct whole life insurance into its "assumed" component parts (term insurance and a savings plan), it has both behavioral and financial limitations. The behavioral limitations come in two forms:  1) adverse selection of consumers and 2) mental accounting in budgeting.

Adverse Customer Selection


“It is important to note that the additional freedom of not being forced to save assumes that people will be willing and able to save on their own. Note that the marketing plan and appeal of this product are primarily targeted to those in middle- and lower-income brackets. This means that the very people who have limited capacity to save and limited access to investment instruments are expected to save on their own… .”[1]
“Term life insurance allows individuals to put off savings until they can more easily afford it later in life. Note that planning to defer savings in this way eliminates the largest chunk of interest they would otherwise accrue, meaning later investments must be larger to make up for the difference. However,the BTID alternative assumes that people will change their behavior in ways that they never have previously by deferring consumption until later in life—easier said than done[!][1][Emphasis added]

Mental Accounting in Budgeting

The second behavioral limitation comes from work by behavioral economists and contradicts innate tendencies in almost all people:
“…the assumed model of behavior in the BTID alternative contradicts some very important and innate tendencies for almost all people, regardless of economic class.  In prefacing this issue, it is important to remember that the assumed behavior in BTID is that people will be able to save the additional amount that otherwise would have been allotted to a whole life premium and invest it on their own. Studies in behavioral economics on people’s tendency to budget have found that people are limited in their ability to perform such for two interrelated reasons.
The first reason is what researchers call mental accounting. Research has found that people tend to place money in “buckets” in their heads and are oftenunwilling to shift these amounts.[2] The following stylized example illustrates how this affects people’s ability to save.
 If someone has allotted a certain sum of money for lunch in the week, but on Monday sees that lunch will be cheaper during the week, instead of saving the difference between what was budgeted and what will be spent, because that person has mentally allotted the whole amount in the lunch or food bucket, he or she tends to either buy more lunch or splurge on a more expensive dinner later in the week.
People’s tendency to consume what could be saved is further enhanced by a second related issue known as hyperbolic discounting. Hyperbolic discounting is the tendency for people to discount by large amounts the utility of something that could be purchased later, thus making almost any purchase today seem more valuable than putting it off for later and saving for tomorrow.[3] This means that even if people can overcome the mental accounting constraint to savings, when they evaluate what they could purchase later from savings, they are more likely to overstate their utility for purchasing something now. In everyday terms, these two concepts combined are a formal way of noting that people tend towards impatience.” [Emphasis added.]
Hence, as applied to Buy Term and Invest the Difference:
When people buy term life insurance, they often frame the difference between the premiums for term life insurance and the whole life insurance alternative as money gained by the transaction. For the two reasons cited above, it would take an extraordinary amount of discipline to allot money toward savings when that money is framed as gained. If left to their own devices, individuals choosing term life insurance are less likely to invest the whole difference as is assumed under the BTID alternative…it is true some companies sell products that combat this by providing investment vehicle options to the insured, but in doing so they reduce the “freedom” associated with this option.”

In the next installment, PART 5, we will begin dicussing: 
What Do Consumers Actually Buy? Voting with Their Feet…or Their Wallets

[1] David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited.” Journal of Financial Service Professionals 69, No. 3 (2015), 92-103. (LINK)
[2] Richard H. Thaler, “Mental Accounting Matters,” Journal of Behavioral Decision Making 12, No. 3 (1999): 183-206.
[3] David I. Laibson, Hyperbolic Discount Functions, Undersaving, and Savings Policy, Working Paper (National Bureau of Economic Research, June 1996); accessed at:

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