Have you ever heard of “second-order” thinking? It seems like an idea I am hearing more and more frequently as of late. I became much more aware of the concept after I read Ray Dalio’s book Principles, although he uses the phrase second order consequences. For those of you that don’t know who Ray Dalio is, he runs the largest hedge fund in the world – Bridgewater Capital – and his market returns speak for themselves. Another investor who is known for this thinking is Howard Marks who talks about it in his book The Most Important Thing and whose investing track record, again, also speaks for itself.
“Second-order” thinking has traditionally been most associated with the investment world but it can and should be applied to most of the decisions we make. Second-order thinking is basically looking beyond the obvious or assuming that all decisions are binary. It is recognizing that a multitude of variables could impact a decision and that a decision can manifest itself into something that was unexpected. Basically it is foregoing the immediate ease or satisfaction of a decision because you understand there are long term implications that could be unintended or harmful. An extreme example is being offered a cookie. Most people would go through an instinctive decision making process where all that mattered was whether they were A) hungry and B) like cookies. Second-order thinking would contemplate those two inputs but the decision making process would go beyond that and ask what happens after the cookie is consumed. Maybe it would lead to diabetes down the road, maybe you feel overwhelming guilt that outweighed the pleasure from eating the cookie leading you to be in a funk for the rest of the day, maybe you would feel you needed to go to them gym an extra day that week giving up precious time with your family, and so forth and so on. As you can see, second-order thinking is looking beyond the immediate consequence of a decision and instead at the domino effect of that decision.
A real life example of a second-order thinking would be a professional quarterback. A QB goes to the line of scrimmage with a pre-determined play call and the offense lines up accordingly, but then he reads the defense and recognizes that the play they were going to run has a low probability of success against the defense so he changes the play to something he believes has a higher probability of success. He might call a play where one of his receivers does a short crossing pattern that forces the safety to come up which in turn creates one on one coverage (a favorable matchup) for the receiver going deep. As you can see, the QB not only needs to recognize what type of defensive scheme is being used, but how the defense would respond to certain offensive plays, call the play that is best suited to be successful against that defense, identify where the weakness will be against that defense, and finally execute and exploit that weakness. He has just a few seconds to process this information and execute. A great professional QB needs to not only be a great athlete but be a second-order thinker.
First-order thinking, on the other hand, is the path of least resistance. It is looking no further than the immediate consequences of a decision we might make. With first-order thinking we try to make things binary and we look at the immediate consequences of that decision which are typically either good or bad. When we use first-order thinking we don’t look at root causes or try to ascertain why something is what it is, a rudimentary example would be buying solely off of price. The second-order thinker might instead try to figure out why the products are priced so differently – is it quality, brand-name, type of warranty, backend customer service? Once that information is collected they can make a better decision for what suites their needs.
In insurance, first-order thinking is the predominant way of thinking for both the buyer and the seller. The seller or broker understands that a lot of buyers think of insurance as a commodity, there is not much difference between policies, so they push price or service. The broker also recognizes that most buyers do not really understand insurance so they might use their brand name recognition and position themselves as an “expert.” A few of the phrases that I have heard that signal a buyer is a first-order thinker are:
- CFO (buyer): We have always purchased insurance this way.
- Risk Manager (buyer): We’ve been with our broker for four years and never had a problem.
- CFO (buyer): Our broker just saved us a bunch or money.
- CFO (buyer): They insurance XX% of the Fortune 500 companies.
I could go on and on, but the point is that in insurance it is easy and definitely the path of least resistance to be a first-order thinker. Most buyers, and brokers, do not want to get into the weeds of a policy and ask the “what if” questions. An incumbent broker will seldom say this to a client, “X is not in your current property policy, should it be?” They might say you should like at adding cyber coverage or employment practices liability coverage, but rarely will they tell you something is not in your policy unless you as the buyer bring it up. Unless you are a company that is fortunate enough to have a risk manager, it is hard to become a second-order thinker when it comes to buying insurance, CFOs or whoever is in charge of insurance, have too many other things that they are responsible for. Really the only way I know for a company to think on the second-order when it comes to insurance is having a third party review your program and ask you the questions your current broker either doesn’t know to ask or is afraid to ask because they are afraid of how that might make them look.