Inertia: Transforming Insights into Impact

The irony of obsessive loss aversion is that our worst fears become realized in our attempts to manage them – Daniel Crosby

Tragically, on February 1, 2003, the Space Shuttle Columbia met a devastating fate as it reentered Earth's atmosphere. The harrowing incident unfolded over the skies of Texas and Louisiana, ultimately claiming the lives of all seven courageous astronauts who were aboard the shuttle. It was the second?Space Shuttle mission?to end in disaster, after the?loss of?Challenger?and crew in 1986.

The direct chain of events leading to the?disaster had begun 16 days earlier when the Shuttle was launched. During liftoff, 81 seconds after, a big piece of insulating foam broke off the fuel tank, hit the Shuttle, and damaged important heat protection tiles. The tiles were unable to withstand the extreme heat during the shuttle's re-entry into Earth's atmosphere, leading to their failure.?

Engineers had previously raised concerns about this scenario in a similar incident in 1983, but no significant design changes were made. On the second day of the mission, a foam strike was detected in the launch footage. Despite this, the Shuttle Program management dismissed it as a threat to the mission, spacecraft, or crew.?NASA's Debris Assessment Team also dismissed internal software models that predicted damage deeper than the thickness of the TPS tiles, considering them inaccurate.

To make matters worse, Linda Ham, chair of the NASA Mission Management Team, declined to authorize the request for imagery to assess potential damage to the orbiter, citing concerns that it could distract the crew from their scientific duties.

Despite several clear warning signs, the integrity of the Columbia shuttle was tragically not formally verified before its return to Earth.?

Following the tragedy, the Columbia Accident Investigation Board (CAIB) was formed. After finding that insulation foam hitting the wing was the most likely cause, the Board investigated the organizational culture factors that led to the failure. Unfortunately, this disaster pointed to several examples of bureaucratic inertia at NASA, such as

1. Normalization of Deviance: Over time, foam shedding during shuttle launches became seen as normal and acceptable, despite being observed multiple times. This acceptance of deviation from expected safety standards is a form of inertia, where the default option (accepting the risk) continued despite the potential for catastrophic consequences.
2. Failure to Adequately Address Known Risks: Despite previous incidents and concerns raised about the potential danger of foam strikes, there was insufficient action taken to fully address and mitigate the risk. This inaction can be seen as a product of organizational inertia, where the complexity and cost of making changes, combined with an underestimation of the risk, led to a continuation of the status quo.
3. Decision-Making Processes: The decision-making processes leading up to and following the foam strike on Columbia were marked by assumptions that the shuttle was safe to land without further inspection. This assumption, despite the availability of methods to inspect or repair potential damage, demonstrates inertia in adhering to pre-established beliefs and procedures, even in the face of new evidence.

Just as in the case of the Deepwater Horizon disaster and Hurricane Katrina, (discussed in Part 1) the Columbia disaster serves as a poignant reminder of the dangers of inertia in complex systems, where the failure to act on known risks, challenge assumptions, and adapt to new information can have tragic outcomes. It underscores the importance of cultivating a culture that prioritizes safety, acting towards disaster prevention, continuous learning and adaptation.

In Part 1 of our discussion on Inertia, we identify the key drivers behind the Inertia bias. Particularly, we explored the tendency to prefer the default ‘no-action’ choice. Defaults offer an easy mental exit from the fog of deliberation and offer a path of least resistance. In addition, we also explored Prospect Theory and how the concepts of loss aversion and reference points can lead to inertia and risk seeking choices. In this article, we explore how we can overcome the inertia bias. We will also discuss a few more manifestations of prospect theory in day-day business and take away key learnings.

As you will recall, the Prospect Theory Value Function entails three key psychological principles: Loss Aversion, Reference Point dependence and Diminishing Sensitivity. We will now discuss how these factors interplay in individuals and institutions’ decision choices.? and how we might engineer different, more ‘risk-averse’ outcomes by reframing how the choices are presented. The role of the reference point, which represents the Status Quo – hence inertia, is one of the key determinants.

Inertia in Action

To truly tackle inertia, we dive deep into its manifestations within three critical decision makers: consumers, business leaders, and emergency managers. Quality choices, vital for our safety and financial well-being, often suffer from decision paralysis. By concentrating our discussion, we aim to uncover actionable strategies that can lead to significant societal and individual benefits. We will evaluate examples in Consumer Choice (Personal Finance & Insurance), Business Strategy and Disaster Planning. In each category, we will discuss interesting manifestations of inertia and tips to overcome it. In many instances, we find that heightened awareness of the bias is itself a key factor in mitigating its impact.

Consumer Choice

We have seen how defaults are often the preferred choice. Well, fortunately, defaults are malleable.? One can design choices where the default choice is the preferred ‘risk-averse’ choice. This concept is discussed extensively in the book Nudge, by Thaller and Sunstein, who recommend policies that structure default options that “nudge for good!”.?

A classic example of this is demonstrated in how New Jersey and Pennsylvania offered their residents' auto policies. One offered a low-priced policy with limited tort coverage as the default option, while the other offered a high-priced policy with unlimited tort coverage as the default. There was no tangible difference in pricing or other terms. Quite surprisingly, it was observed that the take-up rate for limited tort in New Jersey was 80% versus only 25% in Pennsylvania.

A similar pronounced uptick in employee voluntary retirement plans (401k) enrollments is seen when new employees are automatically enrolled (default) into the company 401k plan with an option to opt-out as opposed to being given the option to opt-in. When automatically enrolled, almost 90% stay with the plan, even though they have the option to opt-out with a click of a button. However, when given the choice to opt-in - only 30% choose to enroll!

Extending this idea to the broader insurance segment provides some interesting thoughts. How should insurance coverage options be offered and delivered in light of status quo bias? Offering either certain coverage exclusions that an insurer determines are warranted and/or offering additional coverages that benefit Insureds from a risk perspective as default options in light of natural inertia bias may lead to higher take up rates for the product. It is worth emphasizing that the primary goal and intent should be to nudge towards the right amount and type of insurance. The goal is to help individuals adequately understand their risks and take appropriate mitigation strategies through the purchase of necessary coverages and other risk reduction activities.

As we shift from understanding the behavioral roots of inertia in Consumer Choice to its impact on Finance and Insurance, it's clear that the psychological principles influencing our personal decisions echo loudly in the broader financial strategies shaping our world. Let's explore how these insights pave the way for more informed and proactive choices in our financial lives.

Personal Finance

An interesting demonstration of prospect theory and loss aversion is in understanding how people trade financial assets over time. It is observed that both individual investors and mutual fund managers have a greater tendency to sell stocks that have risen in value since purchase, rather than stocks that have fallen in value. This behavior is puzzling because, over the horizon that these investors trade, stock returns exhibit “momentum”: stocks that have recently done well continue to outperform, on average, while those that have done poorly continue to lag. As such, investors should concentrate their selling among stocks with poor past performance—but - but they do the opposite.

The apparent unwillingness to sell stocks at a loss relative to purchase price has an important counterpart in the real estate market. Using data on Boston condominium prices from the 1990s, it was found that two condos with the same expected selling price, but where one is expected to sell for less than its original purchase price while the other is not, then the ask price that the seller posts for the former is significantly higher than that for the latter, on average.

Catastrophe Insurance Puzzle

A major puzzle in insurance economics is the fact that people under-insure low-probability, high-consequence risks and over-insure moderate risks. In other words, economists are perplexed as to why people insure their cell phones but not their homes! Studies of insurance demand often suggest that individuals seem to either ignore or at least undervalue low-probability events. For rare but high-impact events, insurance is often not attractive. The consistently missing demand for catastrophe insurance and coverage of other low-probability–high-consequence risks is often referred to as the?catastrophe insurance puzzle?(CIP). People show reluctance to insure low-probability-high-consequence events even if they have disastrous consequences yet insure against small high-probability losses.

The behavior behind the catastrophe insurance puzzle could potentially be explained by Prospect Theory. As we have discussed previously, individuals may naturally underestimate the likelihood of low probability and high consequence events. The associated gain or payout from such a contract is perceived as low likelihood outcome and with an uncertain future timeline. At the same time, premium payment is perceived as an immediate loss. So, we have an asymmetric option set. The Status Quo is no insurance, premium payment results in a certain loss from status quo (loss aversion), while the potential gain (with a value not as strong proportionally as the loss) is an uncertain outcome. Faced with this choice, most individuals prefer the status quo. No action.

How does one explain the high demand for moderately probable loss events, such as bike theft or even a preference for lower home insurance deductibles? The reasoning here is completely reversed. Due to the relatively high probability of the event, individuals can envision a loss event. The aversion to the loss is stronger than their aversion to the premium (premium is expected to be a fraction of the limit purchased).

Annuitization puzzle

At the point of retirement, people allocate a much smaller fraction of their wealth to annuity products than normative models suggest they should. Again, the choice for status quo may be explained by prospect theory. If someone purchases an annuity at age 65 and dies at age 66, this represents a large “loss”: the individual paid a lot for the annuity but received very little in return. Conversely, if this person lives until the age of 90, this represents a large “gain,” in the sense that much more was received from this represents a large “gain,”. As discussed above, losses loom larger than gains! Even though, given current life expectancies, the probability of the individual dying at 66 is much lower.

Business Strategy

As discussed above, Prospect Theory implies an asymmetric preference between gains and losses. The key finding is that when it comes to gains relative to status quo, decision makers tend to be risk averse – they are more cautious and prefer “more certain” bets. However, when it comes to decisions that involve losses relative to status quo, they tend to be more risk seeking. It is interesting to extend this idea to a broader business context.

Business Development

Let’s say that two separate decisions are contemplated, one a new business opportunity with potential for revenue growth and a second one involves scaling down an existing loss-generating product line. According to Prospect Theory, the pain of losing the revenue from the second decision would be more than the pleasure of the new revenue from the first decision. The risk seeking behavior would be to roll the dice on the loss-generating business for an additional period, perhaps in the hope that more analysis or information will reduce the need to incur the loss of revenue or at least the amount of it. This tendency is also known as the Sunk Cost Fallacy. On the flip side, the risk averse tendency on the first decision would lean towards more caution in regard to the upfront investments and potential chance that the anticipated gains do not pan out as expected. In either case, the decision maker is steered closer to status quo.

Marketing & Product Design

Insights from Prospect Theory open the possibility to describe or frame the insurance purchase decision in a way that it is a gain rather than a loss compared to a reference point. For instance, when discussing two fairly-priced insurance coverage options (or alternatively renewal vs. expiring), if the reference point is based on premium, an increase in premium for the broader coverage option, even if it is fair, is considered a “loss”. Therefore, it will hold a greater sway in the insured’s decision to forgo the additional coverage. However, if the dialogue is centered on the insured’s wealth (a different reference point), and how the broader coverage can reduce the net loss under past or future loss events, they would be more inclined to consider the option with the lower loss potential even at the higher premium.

Deductibles vs rebates

Most insurance policies do not completely shift risk from the insured to the insured. The most important reason for this is that the insurer wants to reduce moral hazard, that is, they want consumers to act responsibly by sharing some of the risk. One of the common features for sharing risk is to use a deductible. Unfortunately, consumers hate deductibles even if they can result in premium savings! The tendency towards loss aversion is also a reason why raising deductibles is such a hard sell. Insureds see this as a loss from status-quo.

Interestingly, studies have shown that raising the price is more palatable than raising the deductible – the former is farther out from the status quo in the Prospect Theory value function – there is diminishing sensitivity to premium change. It has also been observed that an increase in deductible and premium is much better received when tied to a “no-claims” credit or a pool dividend, subject to regulatory protocols. The credit (or dividend) compensates for the perceived loss due to the deductible increase. It also has the added benefit of incentivizing risk mitigation and loss prevention and has been demonstrated to be more palatable while reducing the sensitivity to Premium changes.

Disaster Planning & Emergency Management

There are two main implications of inertia bias for disaster planning.

1. Planners should be aware of loss aversion in their own decision-making. and
2. They should anticipate loss aversion in the actions of other stakeholders.

The first is harder to implement than the second. Loss aversion is partly a psychological effect, and it is very important for decision makers in hazards and disaster planning not only to know which suboptimal decisions they made, but also to know how they can improve hazards planning decision-making.

As we have noted, prospect theory suggests that people are risk averse in the gain domain and risk seeking in the loss domain. Thus, they will work to maintain status quo. As long as existing hazard mitigation arrangements are satisfactory, people are not prone to break them in order to make gains. This can limit progress as communities maintain suboptimal disaster risk reduction rather than seek an improved outcome.

The second implication arises from the fact that for most disaster planning scenarios there are winners and losers. Due to loss aversion, those who are negatively affected by the disaster planning policies will be much more resistant to change compared to those who are positively impacted.

Loss aversion also plays an important role in disaster planning negotiation and bargaining. Studies show that participants in a negotiation and bargaining process are more likely to reach an agreement when the outcomes are framed as gains than when they are framed as losses due to the loss aversion effect. This is because people try to avoid losses and do not accept hazards and disaster planning options that are framed around losses.

Finally, it is important for decision makers to be aware of attempts by vested interests to use framing effects to manipulate public opinion towards status quo.

Recap: Strategies to Address Inertia

Education, Framing and Communication

Effectively communicating risks and the benefits of preventive measures in terms of loss avoidance can motivate action. For example, framing insurance as a way to secure peace of mind and financial stability in the face of disaster can appeal to individuals' aversion to losses. Highlighting the certainty of protection that comes from insurance or mitigation measures can address low-probability, high-impact scenarios, leveraging risk aversion in the domain of losses.

Reframing the situation to highlight the long-term impacts of decisions can shift institutional perspectives. For instance, the potential for significant reputational damage from a disaster can be a powerful motivator for action for large corporations, such as BP. In fact, reputational risk, an intangible measure, is one of key risk factors in many corporate risk management policies.

Subsidies and Incentives for Mitigation Measures

Providing financial incentives or subsidies for homeowners to invest in mitigation measures or purchase insurance can offset the immediate sense of loss (spending money) with a tangible gain (reduced premiums, increased safety). As discussed above, rebates and no-claims bonuses can be part of such a package.

Similarly, financial and regulatory incentives can be tailored to encourage institutions to take preventive actions against high-impact, low-probability events, overcoming the natural tendency towards loss aversion in these scenarios.

Effective Policy Design: Default Options

Governments and organizations can design policies and incentives that align with natural decision-making tendencies. For low-probability, high-impact disasters, making insurance purchase or home retrofitting the default option leverages risk aversion to ensure protection. By making disaster insurance or specific preventative measures the default option, policies can effectively harness the power of inertia for positive outcomes. People are more likely to stick with a default option, even if it involves some cost, than to opt out.

As we conclude our exploration of inertia, the real work begins: identifying where inertia might be silently influencing our decisions and taking conscious steps to counter it. Whether it’s reevaluating your financial portfolio, considering insurance options with a fresh perspective, or advocating for proactive disaster preparedness in your community, what will be your first step towards action? Share your strategies and stories with us, and let’s navigate the path from inaction to action together.