behavioural-economics

Behavioural economics:
Driving better customer
outcomes
Financial Services Risk & Regulation: Conduct & Customer/February 2014
Summary p01
/What is behavioural economics p02
/ Why is behavioural economics important
in financial services? p03
/ Behavioural economics in action p06
www.pwc.co.uk/conduct

Behavioural economics | Driving better customer outcomes
The study of behavioural economics can provide valuable insights into the
predictable biases and inherent cognitive limitations of how and why
customers make poor financial product decisions. With these behavioural
insights, firms can develop strategies, products and information which
encourage customers to make better financial decisions, improving the
financial outcomes for the customer, building greater customer-centricity
within firms and ultimately taking a significant step in helping rebuild
trust back into financial services.
This paper sets out what behavioural economics is, why it should be at
the forefront of strategy and customer agenda, and provides a number
of potential key impacts to current business.
Behavioural economics

1January 2014
Financial services firms can gain a first-mover,
competitive advantage in the market by using
behavioural economics as the tool to build a
compliant, sustainable, and customer focused
business model. The growing importance of
putting customers at the heart of business and
a comprehensive change in the direction of
regulatory pressure has brought behavioural
economics to the forefront of the financial services
industry. The FCA have stated their intentions to
use behavioural economics as a tool for future
investigations and reviews, and firms which have
significant customer impact are outperforming
the market. If firms act quickly, they can utilise
these changes for a considerable opportunity.
Behavioural economics is the study into the way
humans make economic decisions, challenging
the classical economic view that humans make
Summary
perfectly rational decisions. It is of particular
interest within the financial services industry
where products are complex and require people to
make decisions that will affect them over a long
time period. The tool of behavioural economics
is useful for lots of different functions of the firm.
It can have an impact on strategy, through to
affecting how firms design their products.
Successfully understanding and implementing
behavioural economics across a combination of
the different functions of the firm can lead to
firms creating a customer-centric and sustainable
business model and reach better outcomes for the
firm, and the customer.

2 Behavioural economics | Driving better customer outcomes
What is behavioural
economics and why is it
different from traditional
economic thinking?
The traditional study of economics has
been based on the underlying assumption
that when people make a decision, they
make the right, rational decision. This is
because they are assumed to have perfect
knowledge on all of the options available
to them, what the full outcome of each
option will be, and have the cognitive
capacity to process everything that may
affect the decision. They are assumed to
make the decision completely selfishly,
maximising the amount of utility, or
benefit, they receive from making that
decision, regardless of how it affects
anybody else.
Studies have shown that humans
are not the all-knowing, perfect
creatures traditional economics
assumes.
1 Kahanman, D. Thinking Fast, Thinking Slow, Penguin, 10/05/2012
2 Hodgkinson, G. & Starbuck, W. (Eds) The Oxford Handbook of Organizational Decision Making, OUP, 24/03/2012
Behavioural economics
concentrates on explaining the
economic decisions people make
in practice, especially when these
conflict with what conventional
economic theory predicts they
will do. Behaviourists try to
augment or replace traditional
ideas of economic rationality with
decision making models
borrowed from psychology.
In reality, people do not act in this
manner and behavioural economics is
the study into how people really act,
challenging the underlying rational
consumer assumption.
Research tells us that humans do not
always make logical rational decisions.
By their very nature, humans make
decisions based on non-logical factors
like emotion, past experience or without
having or understanding all the
necessary information.1,2

3January 2014
Why is behavioural
economics important in
financial services?
a. Products offered are inherently
complex for most people
Financial products tend to have multiple
features and complex charging structures
and for many can be abstract and
intangible. This contrasts with most
tangible products where customers can
easily understand what they are
getting and the product has a single,
simple price. Faced with complexity,
customers may simplify decisions in
ways that lead to errors, such as
focusing only on headline rates.
Furthermore, customers may place
reliance on advice which makes issues
of trust and persuasion of key
importance in financial services.
b. Many products involve trade-offs
between the present and the future
People commonly make decisions against
their long term interests because of a
lack of self-control, e.g. borrowing
excessively using payday loans.
c. Decisions may require assessing
risk and uncertainty
People are generally bad intuitive
statisticians and are prone to making
systematic errors in decisions involving
uncertainty.3
Therefore we often
misjudge probabilities and make poor
insurance or investment decisions.
d. Decisions can be emotional
Decisions on which financial products
to buy can have a great and long term
effect. As a result decisions can be
driven by stress, anxiety, fear of losses
and regret, rather than the costs and
benefits of the choices.
e. Some products permit little
learning from past mistakes
Some financial decisions, such as
choosing a retirement plan or mortgage,
are made infrequently, with little learning
from others, and with consequences
revealed only after a long delay.
As financial products usually have
a substantial effect on the long term
wellbeing of customers, a poor decision
made can have a highly significant
effect on the consumer. Therefore,
an understanding of behavioural
economics and how it can affect a
client is crucial to a financial services
firm’s performance – ethically as well
as financially.
The products which people are
offered within financial services
are unique for a number of reasons.
Including:
3 Kahanman, D. Thinking Fast, Thinking Slow, Penguin, 10/05/2012

Why is behavioural economics becoming
increasingly prevalent in financial
services now?
There are two main drivers as to why
behavioural economics has emerged
as such an important tool to the future
of financial services firms – regulation,
and the rise in the importance of
customer focus.
Regulation
The FCA have published two papers
this year on the topic of behavioural
economics and Martin Wheatley (CEO)
has said that ‘the FCA will be using
behavioural economics in the
years ahead’.4
They plan on using
their regulatory authority to change
market practice in areas where
customer behaviour is being used to tie
customers into potentially poor
outcomes. Firms need to make sure
they are not using behavioural
economics in an exploitative way.
The FCA are already conducting
reviews and investigations with a
behavioural economic basis. They
have launched a review into price
comparison sites to look at ‘whether
certain deals are promoted above
others and whether the focus of these
websites on price means customers fail
to get the best deal for their needs.’5
4 Martin Wheatley, FCA Chief Executive, ‘The human face of regulation’, speech at LSE, 10/04/2013
5 Clive Adamson, FCA Director of Supervision, para-phrased in the article ‘FCA probes ‘misleading’ price comparison websites’ by Lucy Warwick-Ching at
www.FT.com, 25/11/2013
FCA outlined signs and indicators of behavioural economic exploitation
Sign Sample indicators
Firms 1. Rip-Offs
Uncompetitively high margins
• Persistent excess profitability
• Price dispersion unrelated to cost
• High penetration rate for high-margin unessential add-ons
2. Suckers
Concentrated profits from
a small group of customers
• Cross-subsidies between customer groups or products
• Very different financial sophistication across targeted customers
Product Features 3. Bargains
Innovative products that
appear very cheap
• ‘Too good to be true’ headline prices or returns
• Some material charges of exclusions are hidden or
under-emphasised
4. Traps
Contract features that often
target behavioural biases
• Teaser rates, especially if with automatic renewals
• Cancellation charges or other hurdles
• ‘Default’ options for some key contract elements
(e.g. opt-out purchase for add-ons)
Customers 5. Regret
Reported or potential regret
• Widespread reports of customer regret not caused
by foreseeable risk
• Product purchased rarely – little scope to learn
6. Folly
Choices out of line with
common sense
• Product inconsistent with other products owned of with stated
goals
• Product clearly provides poor value from some groups
of customers
7. Confusion
Observed or likely confusion
• Customers unable to describe key product features or prices after
purchase
• Product complicated for some or all because of structure
of number of options

5January 2014
Further, there is external pressure on
the FCA to conduct more reviews and
investigations using behavioural
economic grounds. The Financial
Services Consumer Panel (FSCP) has
called for a review into the provision
of annuities, claiming that “They
(insurance firms) can say to them
(customers) it’s very good to shop around
but they are benefitting from people’s
anxiety and a lack of information.”6
However, to help firms prepare for
regulatory scrutiny, the FCA has
outlined the following indicators they
are likely to use to highlight trends or
unexpected indicator values which
could suggest that a firms customer
base is detrimentally impacted through
firm practices/products, and is not in
their current best interest.7
Understanding these signs and
indicators are crucial to the future
business model for all financial services
firms to be regulatory compliant. This
has really brought the attention of
behavioural economics forward.
However, the change in regulation doesn’t
just carry a threat; it also creates an
opportunity for firms to gain a competitive
edge, as it gives an indicator of what the
future landscape of the financial services
industry is going to look like.
Growth in the importance
of customer focus.
A more agile, innovative, risk-conscious
and customer-centric culture is set to be
the primary competitive differentiator in
the new landscape, and the importance
of putting the customer at the heart of a
firm’s business model has been rapidly
growing within the last few years. Since
2008 firms who have mastered the
growth lever of having a high customer
impact have outperformed the market
by a multiple of 2.2.8
This demonstrates
the value that knowing how to address
what your customer wants can add to
performance.
Behavioural economics has been
highlighted as a key tool to applying
the correct solutions to the decision
making problems. Most firms include
customer-centricity in their mission
statement or their vision and values.
Firms need to ask themselves the
extent to which the customer is truly
at the heart of everything they do and
how this translates into everyday
practice. Actively managing behaviours
will result in a culture that aligns
business strategy and leads to
sustainable business outcomes.
These two key drivers – regulation and
the growth in importance of customer
focus have accelerated behavioural
economics to the forefront of the
industry due to factors including
the following:
• The UK market has faced a number
of high profile cases of failure in
terms of meeting customer outcomes,
for example PPI miss-selling. Such
cases provide real-life examples of
how firms have financially benefited
from customer decisions which have
clearly not been in their best interests.
• Trust in financial services is at a
historic low. This has been driven by
organisational failure and lack of
customer-centricity. Behavioural
economics provides a tool to help
understand the inherent human
behaviours and biases within
customers, with predictable results,
which could help firms build
better customer solutions and aide
better customer decisions, helping
rebuild trust.
• Financial services are facing
challenging economic pressures in
terms of margins and competition.
Building better understanding of
real client needs and client decision
making processes will help firms
build strategies which put the
customer needs and values at the
heart of their organisation, coining
the phase “what is good for the
customer, is good for the firm.”
• Macro-economic and structural
changes are impacting financial
services, with significant challenges
in terms of socio-demographic,
geographic, technological,
environmental and political changes.
These long term trends will impact
financial services strategies.
Building customer understanding
will be key to developing long term
sustainable businesses.
• Regulatory developments, such as
Retail Distribution Review (RDR),
have changed the product/service
landscape. Regulatory intervention
in markets to help protect
customers best interests are now
looking at how behavioural
economic analysis can help identify
potential industry issues where
customers have been disadvantaged
through poorly designed products,
insufficient information or insufficient
advice. The FCA has stated that
they intend to use behavioural
economics as a tool in their
supervisory activities.
As financial products usually have a substantial effect on the long term
wellbeing of customers, a wrong decision made can have a highly
significant effect on the customer.
6 Debbie Harrisson, member of the FSCP, quoted in the article ‘Pensioners are being ‘burgled’ by insurers on annuities’ by Steve Hawkes, and Dan Hyde at
www.telegraph.co.uk, 09/12/2013
7 Kristine Erta, Stefan Hunt, Zanna Iscenko, Will Brambley, ‘Occasional Paper No.1 – Applying behavioural economics at the Financial Conduct Authority’,
10/04/2013
8 Based on PwC analysis on publicly available data

The impact of behavioural economics on customer decisions can be
illustrated through a number of examples. The following are just a few of
the many examples which show the breadth and depth of the ways cognitive
inhibitors and biases are present in firms and the industry, preventing
customers making good decisions.
Behavioural economics in action
Investment choices in pension plans
When having to choose investment plans, the rational economic view is that
people will evaluate options well and the more choices available, the more
healthy competition drives out bad options and the better the decision. Having
greater breadth and flexibility of plans on offer ensures that participants are able
to meet their individual needs. However, whilst giving individuals more choices
can increase people’s welfare and participation, more choice means a more
complex decision, and this can have an adverse effect on participation and
investment allocation. Research has shown that there is sometimes a drop in
participation as plan options increase.
Within pension schemes, reducing the number of options can potentially increase
participation. When presented with too many options, people find it harder to
make a decision due to being unable to evaluate and compare all the choices.
There is also higher probability of regretting the decision, as having more choice
also increases peoples’ expectations on the outcome, and consequently the
likelihood of the outcome not meeting their expectations. People are then likely
to feel they made the wrong decision – and regret the decision they have made. To
avoid this regret, people are less likely to opt into the plan at all.
In practice, there was a study on an asset management company who employ over
1 million staff’s voluntary retirement pension plans. The study showed that with
every 10 funds added to choose from, the participation rate fell by 2% – showing
that more choice isn’t always in the interest of either party.
A study on an asset
management company’s
voluntary retirement pension
plans showed that with every
10 funds added to choose
from, the participation rate
fell by 2%.
10 2%
Identifying insurance needs
Rationality assumes that when deciding to buy insurance, people will figure
out the probability of the outcome occurring, and then weight the potential loss
with this probability. They would then insure if the cost of insurance is less than
this amount.
One of the reasons people don’t act rationally in this way is that they are likely to
underestimate uncertainty; people often make predictions on the basis of
observations, believing that these form patterns. As a result, people believe that
when things happen very regularly, they will happen all the time. Therefore, they
overestimate the probability of common events occurring. Within insurance, this
means that people are less likely to insure against some things which they rationally
would as they assume it would never happen. Research indicates that in many
countries, homeowners and individuals are not sufficiently insured against
disaster risk. In addition, people tend to underestimate what the damage caused
from the potential disaster would be, and therefore what their coverage needs to be.

7January 2014
Present bias: Auto-enrolment
Rational economic behaviour suggests that people will make decisions based
on how much it benefits them over their entire life. However, people commonly
respond to urges for immediate gratification – people value satisfaction in the
present more than satisfaction in the future – and as such will make decisions
which benefits them greater in the present.
When it comes to saving, we find that the optimal behaviour for both customers
and firms is for the individual to save more. The individual has the propensity to
under save, preferring consumption in the short term to long term. To help correct
this, there is regulatory or state intervention to increase savings through auto-
enrolment schemes to align desired optimal behaviour with market incentives.
Information asymmetries: Provider loyalty for annuities
A lack of information and sticking to the status quo are two factors which highly
influence people to act irrationally. The annuities market is a good example of
how providers are able to generate huge profits due to these factors.
When an individual wants to buy an annuity with their pension fund, they have
two choices. One option is buying an annuity from the company with whom they
have accumulated their pension fund, and the alternative is to shop around and
choose the best annuity from the range of annuity providers. Research shows that
two-thirds of customers buy their annuity from their current pension provider
despite higher annuity rates being available in the market in which an engaged,
well informed rational customer would choose. This is driven by people being
adverse to change – sticking to the status quo – as well as not being informed of
the other rates available to them.
Loss aversion: Over insuring small risk
Loss aversion can have important implications on insurance. Customers who
are loss averse may over-insure small risks, where the expected value of the
loss is small relative to the cost of the insurance e.g. mobile phone, bundling
cancellation insurance with ticket purchases. Premiums paid for such insurance
schemes are hard to justify in the context of rational economics but can be
explained by loss aversion and overweighting of loss probability. Travel insurance
with small incremental decreases in excess or baggage allowance is often
disproportionally matched with a significant increase in premium.
Information and limited attention to process complex
information; inability to compute: Limited awareness of
financial product fees and expenses
The average consumer of financial services reports tends to be unfamiliar fees
and expenses, even with respect to their own portfolio or products. However, over
the long term, even small fees can significantly erode long term value. Research
has found that fund purchases are sensitive to salient fees, such as front-end loads
but are insensitive to less salient charges such as expense ratios.
Borrowers may pick the lowest, most salient cost, such as the lowest monthly cost
for a credit card rather than focusing on their cost of credit over the expected life
of the card. Firms have introduced options to cater to these behaviours with
attractive low introduction fees.
0%

The potential impact and value of using
behavioural economic analysis across
your business
Business area Impact/value
Compliance and risk Using behavioural economic metrics, such as those identified by the FCA (see table on page 4),
to help firms identify early instances of potential customer detriment, enabling proactive
management of product and services suitability for customers
FCA supervisory approach is anticipated to incorporate a focus on behavioural economics.
Developing an understanding and being able to provide evidence of behavioural economics in
action across a firms’ products and services, supporting better customer outcomes, will become
increasingly important
Strategy Building an understanding of the behaviours which drive customer decisions aides the
development of product and service strategies focusing on better customer outcomes. Such
strategies will help rebuild trust with customers at a firm and industry level
Developing behavioural economic led strategies will help evidence customer-centricity in strategic
approach and leadership culture
Becoming an early adopter of behavioural economic led strategies, developing products and
services which help deliver better customer outcomes will strengthen competitor positioning
through product/service offering and pricing
Human Resources Using behavioural economic testing to help assess potential candidates customer-centricity in the
selection and promotion processes
Using behavioural economic metrics to build performance management and compensation
systems, reinforcing and rewarding customer focused behaviour
Providing ongoing training on behavioural economic concepts and the associated understanding
of customer behaviours in their decision making processes as a major component of customer-
centricity training and development at all levels
Customer team Building understanding of what customers actually value and how decisions are made in terms of
product, service and attributes
Developing greater customer understanding through client segmentation based on behavioural
economic concepts
Product Using behavioural economic metrics and conceptual understanding of decision making to develop
product and servicing offering to counter poor customer decisions
Building pricing strategies which are transparent and reflect customer value, helping customers
determine true value of products and services
Marketing Understanding how people will react to different types of campaigns will have a substantial
impact on how firms develop strategies and materials
By focusing on what and how information is received and interpreted by customers, improving
transparency and clarity of information in marketing and product information, overcoming
information asymmetries and aiding decision making processes
Positive use of behavioural economics as a tool to build trust and reputation into brand
Distribution channels Improving face to face interactions with greater understanding of the customer and customer
decision making
Developing advice and service models, reflecting the impact of behavioural economics
With this wide spectrum of interest in behavioural economics as a tool to aide firms and help customers make
better decisions, we believe behavioural economics should be of interest across a wide audience within your firm.
There are opportunities and instances where the use of behavioural economics should be central to your daily and
strategic operations and activities.

9January 2014
To help firms develop their strategy,
customer agenda and to prepare for
regulatory expectations, there are a
number of practical activities they
could consider undertaking; including
in the design and pricing of products,
the information they provide, and in
the advice they give to customers.
Product and pricing
• Undertaking detailed client
segmentation to understand
different client needs.
• Undertaking client ‘value’ research
to understand what customers
value in terms of product/service
attributes and developing products
which reflect these outcomes.
• Developing fair and transparent
pricing structures, for example
fair-value pricing.
• Providing ‘portfolio’ of services to
help clients understand how a new
product/service/feature will fit
(compliment/conflict) with existing
portfolio of products/services/
features already held.
• Defining an optimal number of
product/service options to
overcome decision paralysis.
• Developing detailed metrics, for
example around product/service
revenues and client distribution,
evidencing actual behavioural
patterns with customers are as
intended to help customer make
better decisions.
Information
• Clearly presenting and articulating
variations in product/service
offerings, identifying costs, risks
and benefits. For example providing
illustrative examples of product/
service value verses cost.
• Providing information and analysis
to help customers understand long
term cost/benefit analysis, including
for example tax implications, and
the potential impact of variables to
these long term costs/benefits.
• Providing customers with enhanced
information to help inform
customers of potential probability
and loss factors to increase customers’
evaluation capability, helping them
to make better informed decisions.
• Providing information which is
easily comparable across different
providers, with clear articulates of
the ‘value of attributes’ a product/
service/feature may hold.
Advice
• Assisting customers in their ability
to appropriately identify the ‘best’
choices and decisions to meet their
‘true’ needs and requirements,
through for example, various filtering
options and client segmentation.
• Enhancing the flexibility and ease
of switching between products
and providers.
• Encouraging the use of advice
services such as ‘MoneyAdvice’ –
the government sponsored
advice service.
How can firms use
behavioural economics?
The implications and practical uses of behavioural economics analysis are wide ranging.
It can be used solely from a compliance perspective, however the greater the extent firms use
it to build a customer-centric culture, the greater the opportunity.
To evidence customer-centricity
through behavioural economic
metrics
To understand the customers’
behavioural traits in existing
products and services,
helping to identify potential
products or services which
may not be in the customers’
best interests
To proactively help customers
make decisions which
support their best interests
To actively understand
customer needs by developing
a deep understanding of
customer behavioural traits
and developing tailored
products and services to aide
better customer outcomes

What can PwC do to help?
The time to act is now
Firms are already beginning to realise
the importance of using behavioural
economics to sustainably keep the
interests of the customer at the centre
of their strategy, and in doing so build
more sustainable organisational
success. The chance remains there for
other firms to take advantage too.
To achieve the greatest benefits from
the use of behavioural economics,
firms should act now to incorporate
behavioural economics across all
functions of the firms. This will give
them advantage in the future
landscape of the financial services. The
regulation change is likely to impact
the industry significantly, and the real
winners will be the firms who didn’t
wait, and took the opportunity whilst it
was there. PwC can help firms make
the most of the opportunity by helping
with the following:

11January 2014
Customer
• Review of sales, marketing, advice
approach and advertising
approaches against behavioural
economic triggers.
• Product review process to identify
whether triggers have been missed
intentionally or unintentionally.
• Detailed customer segmentation
research using conjoint analysis
(customer willingness vs need) to
inform strategy and product/
service offering.
• Developing proposition and pricing
strategies.
• Analysing desired customer
behaviours per product/service.
• Designing ‘smart’ information
disclosures (timely, relevant, simple
and easy to understand).
• Measurement of customer
outcomes.
• Provide tools to educate your
customers on how behavioural
economics influences their
decisions.
Regulation
• Undertaking a behavioural
economic diagnostic across the firm
for regulatory preparation.
• Support in building evidence if
investigated by the regulator.
• Help you to become an exemplar of
best practice in the industry.
Behaviour change
• Facilitate a review of the business
strategy to build customer-centricity
into the heart of organisation
success.
• Identification of the key moments
that matter for driving customer-
centricity.
• Leadership development to
understand and role model
customer-centric behaviours.
• Review and redesign of HR levers
to set expectations, develop and
reward customer-centric
behaviours.
• Training to help relationship teams
get to know your customer, your
products and identify potential
‘exploiting’ scenarios.
• Build on/design regular
organisation wide assessments of
customer-centric culture to drive
continuous improvement.

Julie Coates
UK leader – Financial Services
Risk Regulation Practice
T +44 (0) 20 721 23211
E julie.x.coates@uk.pwc.com
Matthew King
Partner – Financial Services
Risk Regulation Practice –
Conduct Risk Culture
T +44 (0) 20 721 22801
E matthew.king@uk.pwc.com
David Kenmir
Partner – Financial Services
Risk Regulation Practice
Conduct Risk
T +44 (0) 20 780 44794
E david.kenmir@uk.pwc.com
Rachel Collins
Consultant – People and Change
T +44 (0) 20 780 42122
E Rachel.C.Collins@uk.pwc.com
Contacts

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