Game Theory and Financial Service Distribution Models

Original article posted on "Separating Value From Bias" Substack here: https://separatingvaluefrombias.substack.com/p/7-game-theory-and-financial-service

When the incentives of the individual aren’t aligned with the collective, the benefits of one individual must come at the expense of another.

So in my last post , I talked about how insurance products provide some of the best financial and investment planning tools for HNW clients but aren’t being properly utilized because of the conflicts of interest between financial advisors and insurance agents.

In this post, I want to show the lack of alignment of incentives between customers, financial advisors, and insurance agents creates a Zero-Sum game system in which each party’s benefits come at the expense of another party.

So the problem isn’t with any one party, but the system they operate that incentivizes them to act in ways that create a worse system than if all parties were to collaborate and work collectively with full information available to both sides to create a better system than the one they operate in.

In order to illustrate this, I’m going to use an example based off a classic economic thought experiment.

Game Theory and the Prisoner’s Dilemma

Assume you and a random person you just met are looking at investment firms and both of you go to a firm with a great brand name.

The investment representative puts each of you in two different rooms and tells each of you to choose between two different investments: a Safe Investment, and a Risky Investment.

Your individual return on the investment, however, is dependent both on what type of investment the other person chooses as well as the investment choice you choose.

The random person gets to pick first and then you get to pick.

But the two of you can’t talk to each other before making the decision.

So when it comes your turn to pick, you have no idea what decision the other person made.

If the other person chose the Safe Investment and you also choose the Safe Investment, then both of you will get a 3% return.

However, if the other person chose the Safe investment and you then choose the Risky Investment, then you will get a 5% return and the other person will get a 0% return.

On the other hand, if the other person chose the Risky Investment and you choose the Safe Investment, then you get a 0% return and the other person gets the 5% return.

If you both choose the Risky Investment, then you both will get a 2.5% return.

The table below summarizes the four possible outcomes described above but in a tabular format so it’s easier to visualize.

The other person’s returns are in red and yours are in blue in each quadrant.

For example, if the other person chooses the Risky Investment and you choose the Safe Investment (top right quadrant), the other person gets a 5% return (number in red) and you get a 0% return (number in blue).

4 Possible Outcomes of Other Person and You Choosing Investment Strategies

Which investment option do you choose?

For the sake of trying to emulate the experiment, take a couple minutes looking at the table above and imagine which option you would choose between the Safe Investment and the Risky Investment given that you have no idea what the other person chose.

The return matrix clearly shows the returns you would receive in blue dependent on the four possible outcomes.

I’m hoping that you take the time to actually think about the options and what you would choose before reading for the answers down below.

You actually thinking about this and selecting an option will help you see what the experiment reveals about the problem with creating human systems in which the individual incentives don’t align with that of the group.

Ok, have you figured out which option you’re choosing?

Is it the Safe Investment or the Risky Investment?

Which one is in your best interests?

Remember you don’t know what the other person chose and your returns are dependent on their choice as well as yours.

Ok time for the big reveal………………………………………………………..

Here’s a summary of the 4 key takeaways you hopefully got from the return matrix table.

1. The best outcome for both of you combined is of course both you and the other person choosing the Safe Investment. That way the both of you are equally splitting a 6% return (you get 3% and he gets 3%). All other options split a 5% return between the two of you which means a 1% return is being lost that nobody gets. This is a loss to the collective.
2. The best outcome for you as an individual, however, is to hope that the other person chose the Safe Investment so that you can choose the Risky Investment and get 5% all to yourself (while the other person gets nothing). 5% for yourself is better mathematically than getting only 3% for yourself by splitting the 6% return.
3. More importantly, as we’ll show in a moment, the best option for you as an individual—regardless of what the other person chooses—is to always choose the Risky Investment.
4. Due to #3 above, the individual incentives here means that both parties should choose the Risky Investment which means both of you would end up in the bottom right quadrant where each of you are splitting a 5% return equally with each person getting a 2.5% return. However, note that the bottom right quadrant is worse off for both of you than if you were to both choose the Safe Investment (top left quadrant) where both of you would end up with a 3% return.

Those of you who chose the Safe Investment are probably having a hard time understanding point number three.

If this is you, the reason you probably chose the Safe Investment is because you wanted to split the 6% fairly between you and the other person instead of both of you splitting a 5% return in unequal or equal ways.

You see this as a way for the two of you to get the most out of the system.

However, your choice to choose the Safe Investment puts you at risk because the only way you split the 6% return (top left quadrant) is if both of you choose the Safe Investment.

If the other person chose the Risky Investment and you chose the Safe Investment, then you would walk away with a 0% return while the other person gets the 5% return (top right quadrant).

That’s a huge liability for you.

Furthermore, even if the other person chose the Safe Investment, then you’re still not better off choosing the Safe Investment. If you did, then both of you would get 3% (top left quadrant). However, if you choose the Risky Investment while the other person chose the Safe Investment then you get a 5% return (bottom left quadrant).

So you choosing the Risky Investment here means you would get a higher return—of course at the expense of the other person who would get nothing. In fact, this is the highest return for you possible of any of the quadrants.

So no matter what the other person chooses from a pure mathematical return perspective you should always choose the Risky Investment because that will always give you the highest return regardless of the choice of the other person.

If you doubt this, review the return matrix above and verify it for yourself.

No matter what decision the other person makes, you always end up with the highest return if you choose the Risky Investment.

There is no incentive for you as an individual to choose the Safe Investment.

The same applies to the other person. They are always better off choosing the Risky Investment as well for the same reasons.

And this is the problem with the incentives in this system.

The individual incentives here means that if both of you are rational you would both choose the Risky Investment and end up in the bottom right quadrant where each of you get a 2.5% return.

However, the bottom right quadrant is worse than the top left quadrant where you both choose the Safe Investment and receive a 3% return.

In other words, each individual party acting separately in his or her best interests ends up creating a worse outcome than if the two parties were to collaborate and work together to create an outcome that is better for both of them together.

So the system the both of you are trapped in is creating incentives to lead you down a path that is actually worse than if the two of you were to work together.

And that’s why the investment representative keeps the both of you separate and prevents you from sharing information and working together. If you were to do this, then invariably both you would agree to choose the Safe Investment and the investment firm would be forced to generate a total 6% return so that could be split between the two of you.

But by isolating the two of you in separate rooms, they force you to make a decision that leads you both to a scenario that ends up only costing them 5% instead of a 6% return so that they can keep the 1% difference as a spread.

The experiment I described above is an economic game theory problem known as The Prisoner’s Dilemma .

High cost of acquisition is borne by end consumer

The point of the experiment is to highlight how creating a system in which the individual incentives don’t align with the collective creates a scenario that is suboptimal for either party.

The reason I bring it up is because it perfectly highlights the problems with the life insurance and financial advisory business models in which the interests of the individual actors are not aligned with each other or that of the system as a whole.

All parties involved—the life insurance agent, the financial advisor, and even you the consumer—act independently in ways that seek to maximize each party’s interest—often at the expense of another party.

In our previous post I talked about how the incentives of the financial advisor are essentially to lure in as many clients as possible, stick them all in the same financial model, and grow an increasing AUM base so that they can charge an ongoing AUM fee while doing as little work as possible.

The insurance agent in comparison is incentivized to sell large policies that pay the highest commissions so that they can collect a large upfront payment regardless of whether the client needs it or not. And unfortunately, the policies that pay the highest commissions also tend to have the highest expenses to offset them—which means that they are typically not the best for the client.

You the consumer are incentivized to try and contact as many financial advisors and insurance agents as you can to find what you feel is the best fit. Each of these financial advisors and insurance agents will spend many hours of unpaid work trying to gain your business.

Only a few of the pitches they do will result in actual business.

What does this mean for you the consumer?

This means that the cost of acquiring a consumer is high. The only way they make this up is by making a lot of money on the customers they do close.

The financial advisor and the insurance agent do this in different ways.

Revenue per Workload vs Years of Relationship

The financial advisor often loses money upfront with every client they acquire because their pay is low relative to the cost of acquiring the client and the upfront work they do in planning and onboarding the client who upfront has a lot of questions and needs.

However, in the later years they are just administering the plan and the client has less questions and demands of the advisor. On top of that, in the later years the financial advisor’s revenue is increasing. Remember that the financial advisor is earning a % of your portfolio’s value. As your portfolio value increases, so does their compensation.

So they are doing less work in the later years of the relationship while making more money in those years. Some refer to this as a “lifestyle practice” because the goal is to build up a large base of assets that pays a large fee with little work relative to the compensation.

The insurance agent’s compensation incentives work differently.

Permanent life insurance agents typically get 80%-100% of the first year premium you pay into the policy and ~3%-5% of the premiums you pay in years 2 and onwards.

That’s a huge amount of compensation in the first year (although over the long-run the compensation is fairly low)

But the reason why this compensation is so high in the first year is because the insurance agent will do a lot of presentations and pitches to potential clients that don’t go anywhere and in which they don’t get paid.

So they have to get paid a lot on the ones they do close.

So they are making a lot of money on the front-end from selling a policy to a client who actually buys a policy, but actually barely breaking even the back-end by servicing that same policy. So in order to have a successful business they constantly have to find new clients.

So while the financial advisor accepts losing money on the front-end so he or she can make a lot of money in the later years with little work, the insurance agent compensation model is to constantly find new people to sell to each year so they can make a large commission of them.

One is a long-term business growth model where you make money over the long-term off a client and the other is a one-time churn model where you make a lot of money in the short-term off a client.

You can think of this like the difference between selling a subscription service (i.e. Netflix, Hulu, etc) which you want the customer to keep the service for a long-time versus a product business model (selling a home, printer, car, etc) where it’s a one-time upfront relationship and then you have to find a new customer.

Neither of this is great for the consumer. The consumers who pay for the service or product from the financial advisor or insurance salesperson are essentially bearing the costs of the sales efforts for all the failed sales attempts for potential consumers didn’t pay anything.

Consumers are to blame too

However, the consumer is not without blame in this system.

There are 3 main reasons why:

1. Consumers like getting “free” advice and services that others pay for

2. Consumer preferences incentivize sales not expertise

3. Consumers like the idea of equality in theory—but want the benefits that come from inequality in practice

1. Consumers like getting “free” advice and services that others pay for

Consumers, as a whole, prefer not to pay for products or advice.

Everyone likes to get something for “free”—or at least the appearance of free. It’s the reason why advisors deduct their fee from the client’s investment account every month instead of sending them a bill that they have to pay every month. If clients had to actually see the bill and pay the invoice they would think twice about whether they were truly getting benefit from the service being provided.

So on an individual level clients seeking to shop and compare different advisors and insurance agents benefits him or herself as the individual is able to extract as much value and advice upfront without paying for it or committing to a service or a product. But on the collective level this ultimately hurts the consumers who do choose to pay for the service or product as they bear the cost for all the free advice and time that was extracted from the system by those who didn’t pay into it.

2. Consumer preferences incentivize sales not expertise

The consumer preference for “free” advice we described above has a transformative effect on those providing the services and the products—namely that only those good at sales will survive.

Those not good at sales will have poor conversion rates between prospects and clients and the high compensation they earn from the few clients they close will not offset the time and effort spent on the prospects that didn’t turn into clients.

This creates a survivorship bias where the people who last and succeed in the business are not those who are necessarily the strongest at understanding and implementing financial services or insurance products, but rather are strongest at selling financial services or insurance products.

This is fundamentally no different than the influencers online who make millions selling courses on “How to Become a Millionaire Doing X” without actually having made a million dollars doing X.

There’s a saying that people do business with those they “know, like, and trust” and never is this more true than when one is selling a financial service or insurance product.

By and large people don’t know, like, or trust financial services or insurance products. They are rightfully weary of them.

In the absence of an ability to assess the value of these products and services on their own, consumers rely on their own biases towards the person selling these products or services to pick people they know, like, or trust to sell these products or services to them.

The two most important questions for the client then become: “How does this person make me feel and do I trust them?”

While these can be valuable questions to ask, the problem with them is that because of the survivorship bias I mentioned above, the financial professionals and insurance agents selling their services and products have a high level of emotional intelligence and can convey this sense of comfort and trust without always having the requisite financial or insurance product expertise or incentivizes that serve your interests as opposed to their own—again similar to the influencers online.

3. Consumers like the idea of equality in theory—but keep chasing after the illusions that come from inequality in practice

Let’s revisit the investment firm thought experiment I brought up at the beginning of this post.

Imagine I have two investment firms and one advertised a 3% return and the other advertised a 5% return and you happen to pass by both of them.

All else being equal which investment firm’s door do you walk into?

My guess is that it’s the one advertising the 5% return.

Of course there’s a catch here.

If you opt for the 5% return you’ll most likely end up with a 0% return (top right quadrant) or a 2.5% return (bottom left). Very few will actually earn the 5% return (bottom left quadrant) that was advertised to them.

But by advertising the 5% return I’m able to get you to walk in the door in the first place. I need enough people to walk in the door who will end up getting a 0% return or a 2.5% return so that they can subsidize the few people who are earning the 5% return.

So I’m advertising the 5% return upside, but not having to fully disclose the extent of the downside risks.

But that’s ok because you won’t really ask about the downside.

And even if you do, remember that my emotional intelligence is so high that I’m able to downplay them in a way that makes you feel totally comfortable and at ease.

On the other hand, the investment firm which is giving everyone a 3% return equally without any of the downside risks isn’t having anyone walk in the door.

So the pursuit of a 5% return that few people get is a lot more appetizing for us to chase after than settling for a 3% return that we all equally receive.

Understanding the Systems We’re A Part of

Ultimately, financial advisors, insurance agents, and consumers tend to act in ways that advance their own individual interests in ways that often come at the expense of one another. This creates a vicious cycle which hurts the collective as a whole.

I often hear well-meaning individuals say things like “all insurance products are bad” or “all insurance agents/financial advisors are greedy”.

My contention with these statements is that they seek to blame the symptoms of the problem instead of the underlying cause which are the incentivizes.

The products and compensation structures are designed around incentivizing humans (both consumers and salespeople) to act in certain ways such that the actions of the many benefit the few.

So are the salespeople inherently “greedy” or do the compensation structures and design bring out that part of their personality?

We’re all products of our environment.

In another environment that “greedy” salesperson is just the local leader of the Girl Scout troop that sold the most Thin Mints in your neighborhood.

But whenever the individual incentivizes come at the expense of the collective, the individual is forced into a Zero-Sum game where his benefit comes at the detriment of another.

And the only reason these incentivizes work is because they’re dependent on a human population that is not financially literate in these services and products and are therefore more prone to making decisions based on their biases than their underlying understanding of how these products can benefit their financial goals.

It's not a trade made in good faith. One party is at a clear disadvantage than the other and is easy to be manipulated because they lack the full information.

The Prisoner’s Dilemma only works to trap the both of you into the worse quadrant if it denies the two parties the ability to collaborate and share information to begin with.

But the more knowledge and awareness the consumer brings to the table, the more the consumer shifts the advantage from the house to their side of the table, the more the many start benefitting instead of the few, then the more the life insurance industry is forced to adopt more equitable incentive structures than the ones currently in place simply so that they don’t end up on the losing side of the very game they created.

Because you can’t trap people into the worse quadrant if they have the tools to escape it and use your tactics against you.