Sandie McHugh and Rob Ranyard Bolton, UK IAREP-SABE Joint Meeting Rome September 3-6 2008

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Credit Consumers’ Payment Protection Insurance Decisions: The Effect of Relative

Cost and Level of Cover

Sandie McHugh and Rob RanyardBolton, UK

IAREP-SABE Joint Meeting Rome

September 3-6 2008

IAREP/SABE ROME 2008 2

CREDIT AND RISK

Consumer Credit – loans increased 3 X in 10 years. - Britons owe more than Gross Domestic Product - Increase in debts – estimated 22% people having difficulties.

Loans - risk that future repayments cannot be met.- changes in circumstances, such as being unable to work.

Consequences of repayment difficulties- Increasing debt – loans taken out to repay other loans - consolidation loans- Spiralling debt = difficulties with other household bills- Insolvent - loss of assets - goods (bailiffs) property (repossession). - Poor credit rating = future loan access

Future expenditure and goals adversely affected - holidays – consumer goods - lifestyle changes.


DIFFUSING RISK OF DEFAULT OF REPAYMENTS

Decision Maker may:-

• Not recognise risk exists - ignore it

• Recognise risk but decide no action necessary

• Recognise risk and diffuse it

- Use insurance to provide cover - Payment Protection Insurance for loans and credit cards

- Use other strategies


Payment Protection Insurance Benefits• Life cover

– if you are over 18 years and below 70 – the balance of your loan in the event of death would be paid in full

• Accident and sickness cover if off work – If you are working, and over 18 and under 65, cover for accident

and sickness (after 30 days off work, repayments would be paid until you returned to work)

• Redundancy cover – If you work more than 16 hours per week, cover for redundancy

(repayments covered up to 12 months); a back-to-work service would be available

• Hospital Cover – If you have retired from work or are over 65 and under 70, cover

for periods of hospitalisation (1/30th repayment cover for each day in hospital repayments covered up to 12 months)


THEORIES 1

• Subjectively Expected Utility Theory (Savage 1954)– People will take the option with better

subjectively expected utility. Predicts that preferences for payment protection insurance will be sensitive to changes in the cost of the insurance and the level of cover.


THEORIES 2

• Bounded rationality (Simon 1957)– Simplified models of insured events. People

have limited cognitive abilities to digest the complexities of different insurance policies and therefore use decision rules and heuristics. This predicts that people will not be sensitive to changes in level of insurance cover.


THEORIES 3

• Huber’s Risk Defusing Operator Model (1997, 2007)

• A risk defusing operator (RDO) is an additional action carried out by the decision maker (DM) and is expected to reduce risk.

• Risk sufficient – search for RDO.

• Successful search – accept RDO or not?

• DM weighs up positive effect of RDO against cost.


HUBER THEORIES 3B

• Payment Protection insurance - a Precaution RDO -compensation for a possible problem with repayment take out insurance at the time of loan decision.

• Huber’s theory predicts that cost of insurance and it’s cover will be evaluated – i.e. will PPI be a suitable RDO?

• Huber’s theory therefore predicts that the cost and cover of insurance will be sensitive to variation.

• PPI or another RDO? Other possible RDO – worst case plan (Using savings if in repayment difficulties)


Aims of Research • To test Choices between Credit with PPI

(different levels of cover and cost) or credit without PPI but with higher APR.

• To investigate consumers’ evaluation of PPI levels of cover (premium or basic)

• To investigate consumers’ ratings of usefulness of PPI cover and willingness of pay for PPI.


HYPOTHESES

• As cost of PPI increases, take up will decrease.

• As cost of alternative credit option without PPI increases, take up of PPI will increase.

• As level of cover is enhanced, the take up of insurance will increase.

• Participants will be willing to pay more for premium than basic cover.

• Perceived usefulness of components of PPI cover will predict choice for PPI and willingness to pay for it.


METHOD • Postal questionnaire-based experiment.

• 4 PPI loan decision scenarios presented for 36 months, – 2 for £7,500 and 2 for £15,000. – Loan choice of Bank A with PPI or Bank B no PPI.

• Bank A with PPI offered 7.2% APR. Bank B, no PPI offered 2 loans at 8.3% APR and 2 loans at 12.9% APR

• Randomised groups design, 2 x 2– Level of PPI cover (Premium vs. Basic)– Cost of PPI (Expensive vs. Budget)

• Correlation design with respect to variables for – Usefulness of aspects of cover, willingness to pay, demographics etc.– 2000 bank customers mailed, 11% response rate

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• Imagine that you have decided to take out a bank loan for £7,500 to be repaid over 36 months. You have been given information from two banks, one of them included the above payment protection insurance (PPI) in their offer, the other does not please consider whether you prefer the terms offered by bank A or B.

Example of PPI Decision Scenario

BANK (PPI) MONTHYREPAYMENT

TOTALCOST

APR

A With PPI £272.09(£252.10)

£9,795.25(£9,075.60)

7.2%

B Without PPI £235.00 £8,460.00 8.3%

(£252.10) and (£9,075.60) = replacement budget priced PPI in 2 versions

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Example from PPI questionnaire

Premium (2 groups) and Basic (2 groups) Cover Variations

1. Life cover: if you are over 18 years and below 70 - the balance of your loan in the event of death would be paid in full.

2. Critical illness cover: the balance of your loan repaid from the time of diagnosis.

3. Accident and sickness cover: if you are working, and over 18 and under 65 - after 30 days off work, repayments would be paid for up to 12 months (or until you returned to work).

4. Hospitalization cover: if you have retired from work or are over 65 and under 70, cover for periods of hospitalisation (1/30th repayment covered for each day in hospital) for up to 3 months (12 month)

5. Redundancy cover: If you work more than 16 hours a week, your repayments met whilst you are out of work.

6. Back to Work Service: free help and specialist advice on finding work if unemployed or returning to work after an accident or sickness

All participants had 1-4 elements of PPI. Two premium groups, also had 5 & 6 & no restriction on accident & sickness cover, and up to 12 months on hospital cover.

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RESULTS 1Total percentages choosing PPI in each scenario across all versions.

28

68

27

66

0

10

20

30

40

50

60

70

Scen 1 Scen 2 Scen 3 Scen 4

PPI %

Pattern for 1 & 3 and for 2 and 4 very similar.


Results 2: Percentage of participants in each version choosing PPI in scenario 1 & 2

010

203040

5060

708090

No 1 No 2

Prem & Expen

Basic & Expen

Prem & Budget

Basic & Budget

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Results 3 : Percentages choosing PPI over the alternative loan at APR 8.3%. Scenario 1

2536

2923

0

20

40

60

80

100

Expensive Budget

Scenario 1

Percent PPIPremium

Basic

Not significant. 2 (6) = 2.75, p = .839

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Results 4: Percentages choosing PPI over the alternative loan at APR 12.9%. Scenario 2

48

87

56

86

0

20

40

60

80

100

Expensive Budget

Scenario 2

Percent PPIPremium

Basic

PPI decision x PPI Cost 2 (4) = 0.74, p = .946 Main effect PPI Cost 2(1) = 29.9, p < .05


Summary of Results from scenarios

• No significant effect of COVER or COST in scenarios 1 & 3 where alternative loan was 8.3% APR

• No significant effect of COVER variation in scenarios 2 and 4 where alternative loan was 12.9% APR

• Significant effect of PPI COST in scenarios 2 and 4 where alternative loan was 12.9% APR

• Significant effect of relative cost, i.e. cost of alternative without PPI

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PARTICIPANTS ASKED TO RATE ELEMENTS OF PPI COVER FOR USEFULNESS.

Premium (2 groups) and Basic (2 groups) Cover Variations

1. Life cover: if you are over 18 years and below 70 - the balance of your loan in the event of death would be paid in full.

2. Critical illness cover: the balance of your loan repaid from the time of diagnosis.

3. Accident and sickness cover: if you are working, and over 18 and under 65 - after 30 days off work, repayments would be paid for up to 12 months (or until you returned to work.)

4. Hospitalization cover: if you have retired from work or are over 65 and under 70, cover for periods of hospitalisation (1/30th repayment covered for each day in hospital) for up to 3 months (12 months)

5. Redundancy cover: If you work more than 16 hours a week, your repayments met whilst you are out of work.

6. Back to Work Service: free help and specialist advice on finding work if unemployed or returning to work after an accident or sickness

What is the MOST per month on top of the loan repayments you would be prepared to pay?

£5.00 £10.00 £15.00 £20.00 £25.00 £30.00 £35.00 £40.00 £45.00 £50.00

£55.00 £60.00


Results 5: Ratings of usefulness of PPI components of cover

Components

Mean rating 1= very useful;

7 = not at all useful SD

Critical illness 2.7 2.1

Life 3.0 2.2

Accident & sick 3.1 2.1

Hospitalisation 3.9 2.4

Back to work 3.6 2.2

Redundancy 3.2 2.2

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Results 6: Ratings of usefulness of PPI components of cover

• All elements of PPI rated as useful by participants in all 4 groups.

• Accident and sickness cover– No difference Premium (until return to work)

vs. Basic (12 months max)

• Hospitalisation cover– No difference Premium (12 months) vs. Basic (3 months)

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Results 7: Percentage of participants and the MOST they were willing to pay for Payment Protection Insurance (per month)

0

5

10

15

20

25

30

35

£5 £10 £15 £20 £25 £30 £35 £50 £55 £60

% respondents

60% prepared to pay up to £10 per month (market rate at least £25).


Results 8 - Willingness to Pay for PPI

• Despite evaluations of usefulness most participants were not prepared to pay average market price (i.e. £5 per £1K)

• Level of cover offered was not reflected in participants willingness to pay. Little difference between premium and basic groups, (basic cover groups prepared to pay slightly more).

Cover Type Mean rating 1= £5, 10 = £60

SD

Premium 2.6 2.0

Basic 3.3 2.8


RESULTS 9. Predicting Choice for PPI

• Hierarchical multiple regression analysis; factors predicting PPI choice

• - not predicted by willingness to pay • - not predicted by demographic factors

• - Sum of ratings of 4 usefulness factors – Critical illness, life, accident & sicknesshospitalisation (provided in all versions)

DID Predict PPI choice.

Dependent variable: PPI decisions. Step 1 (Gender, age, income) % of variance only 2%

Step 2 (PPI usefulness) % of variance 16%

(R = .40, R2 = .16, R2 change = .14, p < .001)


• Take up of PPI did decrease as predicted by SEU and Huber when the cost increased, but only when the alternative without PPI was expensive.

• When the cost of an alternative credit option without PPI increased, the take up of PPI increased. This explains differences in take up between scenarios 1 & 3 where the cost of the alternative loan was relatively less than in scenarios 2 & 4 where the alternative was more expensive.

Conclusion & Discussion 1 – Sensitivity to Cost


• When premium insurance was offered, take up of PPI did not increase significantly, as predicted by SEU and Huber.

• Participants were not willing to pay more for premium insurance than the basic policies.

• Is PPI cover difficult to evaluate in isolation?

• Bounded rationality theory assumes that people use simplifications of decision alternatives rather than look at detail. Does this explain lack of sensitivity to cover? Do people have time or inclination to read the small print to understand complexities of insurance policies?

Conclusion & Discussion 2 – Sensitivity to Cover


Thank you for your time.

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CREDIT CONSUMERS’ PAYMENT PROTECTION INSURANCE DECISIONS: THE EFFECT OF RELATIVE COST AND LEVEL OF COVER.

REFERENCES and Useful papers• Huber, O. (1997). Beyond gambles and lotteries: naturalistic risky decisions. In R. Ranyard, W.R., Crozier and O.

Svenson (eds.) Decision making: Cognitive models and explanations. London: Routledge.• Huber, U. (2007) . Behaviour in Risky Decisions: Focus on Risk Defusing. In:Abdellaoui, M; Luce, R.D.; Machina,

M.J.; Munier, B. (eds).Uncertainty and Risk: Mental, Formal, Experimental Representations. (291-306). Berlin, New York: Springer.

• Kunreuther, H. (1996). Mitigating disaster losses through insurance. Journal of Risk and Uncertainty 12, 171-187.• Loewenstein, G., Weber, E.U., Hsese, C. & Welch, N. (2001). Risk as feelings. Psychological Bulletin, 127, 267-

286.• Office of Fair Trading. (2006b). Payment protection insurance. Report on the market study and proposed

decision to make a market investigation reference. London: HMSO.• Plous, Scott. The Psychology of Judgment and Decision Making. 1996 McGraw-Hill, USA • Ranyard, R., Hinkley, L., Williamson, J., & McHugh, S. (2006). The role of mental accounting in consumer credit

decision processes. Journal of Economic Psychology, 27, 571-588.• Ranyard, R., & McHugh, S. (2005). Consumer credit and payment protection insurance decisions. Unpublished

report, University of Bolton.• Savage, L. J. (1954). Foundations of statistics. Oxford, England: Wiley.• Simon, H.A. (1957) Models of man: social and rational. New York: Wiley.• Simon, H.A. (1990). Invariants of human behavior. Annual Review of Psychology, 41, 1-19.• Szrek, Helena; Baron, Jonathan. The value of choice in insurance purchasing. Journal of Economic Psychology.

Vol 28(5), Oct. 2007, pp. 529-544. • Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157),

1124-1131. • Williamson, J., Ranyard, R. & Cuthbert, L. (2000a). Conversation-based process tracing methods for the study of

naturalistic decisions: an evaluation study. British Journal of Psychology, 91, 203-221.

Contact for further information.

Contact details:- Rob Ranyard, Health & Social Studies, University of Bolton, Deane Road, Bolton, BL3 5AB., UK Sandie McHugh, Health & Social Studies, University of Bolton, Deane Road, Bolton, BL3 5AB, UK

. [email protected]. [email protected]

mailto:[email protected]

Sandie McHugh and Rob Ranyard Bolton, UK IAREP-SABE Joint Meeting Rome September 3-6 2008

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