Tit for tat

I’m sure you know all about the famous ‘Prisoner’s Dilemma’ game-theory thought experiment.

But just in case you haven’t, here’s a re-cap:

Two criminals have been caught by the cops. Let’s call them Jane and John. But the cops don’t have enough evidence to send them away for a three-year stretch for major crimes. They can only nail them for minor misdemeanours that would put them behind bars for 12 months.

So the cops offer a plea bargain to each.

If they rat the other out they walk free, but the other gets three years. But if they both turn for the prosecution, each gets a two-year stretch. If they both keep schtum, they get a year apiece.

The two criminals are in separate cells and can’t communicate with each other.

Four permutations are possible. Jane rats on John, John rats on Jane, both betray each other, or both keep quiet.

The scenario is so interesting to psychologists because running through the logic, each prisoner is rationally better off if they betray the other. That is if Jane betrays John she might walk free and even if John also betrays her she gets only two years, which is still better than the three she would get if John betrayed her and she didn’t reciprocate.

But the way the penalties are structured, each is also incentivised to cooperate. If both are nice to each other, this means only a collective two years in jail whereas the two scenarios where one betrays another are three and mutual betrayal is a hefty four.

That’s why it is a dilemma!

What’s this got to do with insurance?

Well, the dilemma gets much more interesting when you turn it into an iterative game that is played repeatedly. It has the same rules but at the end of each round, John and Jane get to find out what the other did. With its annual renewal negotiations, the buying and selling of insurance is much more like this variety.

The political scientist Robert Axelrod popularised this version of the dilemma. He asked fellow academics and advertised to get people to submit different strategies to play it as a game. Then he played each strategy out against the other and totted up the scores.

The winner was the simplest – a strategy called ‘tit for tat’. Tit for tat’s first move was always not to betray the other prisoner, but in subsequent moves it simply did whatever the other player’s last move was: “I will do unto you what you do to me.” Literally tit for tat.

Over the years and millions of iterations, tit for tat and lightly tweaked variants of the same strategy have always won the game.

Axelrod’s insights, which he codified in the book The Evolution of Cooperation, are that the best strategies are ‘nice’ – that is to say, they are the ones that are never the first to betray the other player.

They are also forgiving. For example, tit for tat is infinitely forgiving. It can be betrayed 500 times in a row but will immediately cooperate as soon as the other player comes into line.

But of course, they may be nice but these strategies are not pushovers by any stretch of the imagination. They will be provoked immediately into retaliation.

The final point is that they are not greedy. They are not overtly setting out to score more than the other player but end up doing so over the long run.

Being nice works
Now for the insurance part. Let’s turn this game into one of risk manager and underwriter, and try to apply Axelrod’s learnings:

The most important lesson is that being nice works.

In the simplest terms, the nicest risk mangers generally get better deals more than they get ripped off, because brokers and underwriters simply like and trust them more and want to help.

The same goes for underwriters. Nicer underwriters always get a better showing, most commonly because they are able to decline risks without offending brokers. This way, they keep them coming back again the next day with potentially better submissions.

It’s also hugely important to remember that insurance is a contract of utmost good faith. This reflects the imperfect nature of the deal. The risk owner doesn’t know everything about the risk and neither does the underwriter.

There is material uncertainty and it is explicitly recognised that faith in the other party, and a certain willingness to forgive, is going to be needed to make things work.

After all, if we knew exactly what bad thing was going to happen, when it was going to happen and how much it was going to cost, then we would need a savings product or a loan, not insurance.

An underwriter who screams material non-disclosure and sends reservation-of-rights letters at the first sign of trouble is the equivalent of the defector turning ‘stool pigeon’. It’s a betrayal of client trust and deserves retaliation.

The same cuts both ways – real client non-disclosure is a similarly undeniable act of treachery that must also be punished.

In the insurance context, the other main betrayal available to players relates to loyalty on both the buy and the sell side throughout the pricing cycle.

On the buy side, it is the empathy not to push for unsustainable discounts or the widening of coverage in the troughs of favourable markets.

On the sell side, this translates into a willingness to temper rate rises for loyal and transparent customers, despite hard market conditions that might otherwise allow greater exploitation and profit.

Like the prisoners, we both get the chance to rat each other out once in a while, but it’s better for the both of us in the long run if we don’t.

Yet neither of us should be pushovers. Poor behaviour should suffer immediate consequences.

Buyers must walk away from overly harsh underwriters and, likewise, we should expect aggressive buyers, or those with unreasonable expectations, to be dropped by the best carriers.

Toughness doesn’t pay
The final point is the non-envious one. Greedy underwriters and avaricious buyers don’t usually end up doing as well as they think their toughness should merit.

Greedy underwriters get selected against and their portfolios underperform.

Conversely, ultra-parsimonious buyers end up with lower-quality security with a lower ability, and a lower willingness, to pay up when it really matters.

So, as you prepare to play the next round of the eternally fascinating insurance version of this classic game, do pick your strategies wisely!