The apartment next door is on fire. You hear some rumbling in the radiator, and that loose steam valve looks like it might blow. Your laptop is stolen, and it occurs to you that renters or home insurance might be just the thing you need.<\/span><\/p>\n It could be worse: a wildfire is a mile away, and you\u2019ve started to evacuate. Now is not the time to buy insurance. It\u2019s time to get out of harm\u2019s way. Something has started, and there is a reasonable expectation that you may lose stuff or property. Unfortunately, it\u2019s probably too late.<\/span><\/p>\n Rational or not, <\/span>when<\/span><\/i> we decide to get an insurance policy can be explained by science. Behavioral economists <\/span>Amos Tversky and Daniel Kahneman <\/span>call it \u2018prospect theory,\u2019 which <\/span>determines how people decide between risky alternatives based on what they perceive as \u2018gains\u2019 or \u2018losses,\u2019 rather than absolute outcomes. <\/span><\/p>\n Research shows that people are more loss-averse. In plain English, that means losses loom larger than gains.<\/span><\/p>\n\t <\/i>Turns out, losses make us more miserable than gains make us happy<\/a><\/i><\/p>\r\n\t\t<\/div>\r\n\t\t Back to insurance. We rationalize to ourselves whether paying for something that may or may not happen is worth it. Our rationalization process starts by thinking about the probability (between 0-1) of a certain event occurring. Instead of seeking the probability of something happening, we tend to categorize it as \u201cwon\u2019t happen, will happen.\u201d <\/span><\/p>\n For very low probability events, such as a wildfire or flood, we tend to round the probability of it happening down to zero. We can\u2019t psychologically accept that something like this may happen, and often ignore the fact that this event could occur at all. No need to get a policy for something that we perceive as never happening.<\/span><\/p>\n Conversely, for an event we perceive as having high probability – we\u2019ll round it up to 1, and exaggerate the difference between 0-1. <\/span><\/p>\n This is why many people view their insurance payments as a loss for an unknown gain – you\u2019re losing $5\/month for something you don\u2019t expect to happen, like a fire or flood. In this case, you will opt <\/span>not<\/b> to get coverage, viewing it as eliminating an unnecessary monthly expense. You\u2019ll perceive not getting coverage as a gain. <\/span><\/p>\n But this all changes when a low probability event – say a wildfire or flood – <\/span>does<\/span><\/i> happen to us, or even to someone we know. We witness the low probability event unraveling, and the odds now seem much higher. Suddenly, paying a monthly insurance premium appears to be a gain in the face of a huge loss. <\/span><\/p>\n Because of this, people tend to purchase renters or home insurance only after a disaster, and cancel their policies several years later when they perceive the likelihood of a disaster as low again. \u00a0<\/span><\/p>\n Exhibit A: the median tenure of flood insurance is between 2-4 years, while the average length of time in a residence is 7 years, according to an in-depth <\/span>analysis<\/span><\/a> of the entire portfolio of the National Flood Insurance Program. <\/span><\/p>\n So why is it that after facing a risky event, getting property insurance<\/a> suddenly seems worth it (even though the odds of this risky event are still the same)? Tversky and Kahneman call this the <\/span>\u201c<\/span>framing effect<\/span><\/a>:\u201d<\/span> identical situations generate dramatically different decisions depending on whether you see the situation as a potential loss or gain. <\/span><\/p>\n\t <\/i>People adopt risk-seeking attitudes when facing losses, and risk-averse attitudes when facing gains<\/a><\/i><\/p>\r\n\t\t<\/div>\r\n\t\t For example, what would you choose: get $900 or take a 90% chance of winning $1,000 (and a 10% chance of winning 0)? Most would avoid the risk and take the $900, even though the expected outcome is the same in both cases. <\/span><\/p>\n However, if you were asked to choose between <\/span>losing<\/span><\/i> $900 and take a 90% chance of <\/span>losing<\/span><\/i> $1,000, most would probably prefer the second option (with the 90% chance of losing $1,000) and therefore take on the risk-seeking behavior in the hope to avoid the loss.<\/span><\/p>\n The same logic applies to property insurance. When paying a monthly insurance premium is framed as a gain – pay now for help later – you\u2019re more likely to avoid the risk and take up insurance. <\/span><\/p>\n But when paying a monthly insurance premium is framed as a loss – losing money every month – you\u2019ll take the risk and won\u2019t get an insurance policy. <\/span><\/p>\n Insurance companies have the responsibility to properly price risks<\/a>, but also to protect you against unknown events that might happen to you – and hopefully never do. <\/span><\/p>\n At Lemonade, we\u2019ve happily paid out hundreds of claims, from $50 to over $200,000. <\/span><\/p>\n Although we pride ourselves on being fast, easy, and available 24\/7, covering damage already in progress (i.e.\u00a0mold creeping up in your bathroom<\/a>) is not allowed by the policy. And if we did cover it, we would be doing a disservice to our members and the charities they support, and it would raise policy prices.<\/span><\/p>\nProspect theory can explain when we\u2019ll get insured<\/strong><\/h3>\n
Risk-seeking vs. risk-averse attitudes<\/strong><\/h3>\n
![\"Framing](\"\/blog\/wp-content\/uploads\/2017\/11\/chances-1024x408.png\")
<\/p>\n![\"Framing](\"\/blog\/wp-content\/uploads\/2017\/11\/graph-1024x576.png\")
<\/h3>\nWhy do insurance companies care?<\/strong><\/h3>\n