Please answer two quick questions:
1. When negotiating, do you want the other side to be reasonable?
2. Is it a good idea to be reasonable in negotiations?
Everyone we ask says yes to the first question, but answers diverge in response to the second. Academics lean toward yes, but businesspeople and lawyers often hesitate. In legal disputes, contested insurance claims, and similarly adversarial negotiations, they point out, the other party is likely to open with an inflated claim or a lowball offer. If the other side’s position is unreasonable, these practitioners suggest, it makes little sense to be reasonable yourself.
Suppose a customer claims that a problem with a product you sold him resulted in a $10 million loss to his business. After careful analysis, your legal team concludes that the fair value of his claim is just $5 million. How do you respond? A common reflex is to come back with, say, $1 million. The familiar and dysfunctional negotiation dance that follows can be costly for all involved. The parties may eventually converge on a figure close to $5 million, but only after spending a lot of time and money to get there—and harming their relationship in the process.
It would be to everyone’s advantage if parties routinely came to a negotiation with a reasonable offer in hand: If starting positions are realistic, the offers will be more or less aligned, and any negotiation that follows should be relatively civil, speedy, and fair. But how can a negotiator who wants to be fair from the start ensure that his or her counterpart will be reasonable as well?
This question inspired us to propose the final-offer arbitration challenge, a new negotiation strategy for reaching fair agreements efficiently, even when dealing with seemingly unreasonable opponents. Leveraging an approach first applied in labor negotiations in the 1960s, the strategy allows one side to encourage reasonableness on the part of the other by making a demonstrably fair offer at the outset and then, if the other side is unreasonable, challenging it to take the competing offers to an arbitrator who must choose one or the other rather than a compromise between them. We conceived the final-offer arbitration challenge in the course of our work with the global insurance company AIG. As we’ll describe, the strategy could be used in negotiations well beyond insurance.
The Challenge in Action
Insurance companies pay billions of dollars every year to settle claims, employing hundreds of people to evaluate and negotiate tens of thousands of cases. There is good reason to believe that their employees’ decisions are not always optimal, resulting in overpayment on some claims and needlessly costly negotiation over others. AIG’s CEO, Peter Hancock, who was familiar with Daniel Kahneman’s Thinking, Fast and Slow, invited TGG, the consulting firm with which Kahneman is affiliated, to explore solutions. Kahneman recruited Max Bazerman to examine the company’s approach to negotiation. What began as a brief engagement became a large-scale, long-term project to sharpen AIG’s ability to efficiently resolve claims and reach reasonable settlements, reduce costs, and improve its reputation for fairness. Success with this intervention, Hancock reasoned, could ultimately confer competitive advantage.
AIG used the final-offer arbitration challenge in a difficult negotiation with a man who had been injured while working in a factory it insured. The company didn’t want to overpay on the claim, but it also didn’t want to appear unfair in the eyes of its customer, the factory owner. Drawing on the assessments of several outside experts, AIG estimated the claim’s fair value at $1 million to $1.1 million and made an offer of $850,000. The claimant’s attorney countered with $2.6 million—an amount he vehemently insisted was fair.
AIG, confident that its position was reasonable (and that the claimant’s wasn’t), responded with a final-offer arbitration challenge: Present the two offers to a professional arbitrator, who would make a legally binding decision about which was more reasonable. By forbidding an arbitrator to split the difference between two offers, this procedure neutralizes any incentive to be unreasonable, because the arbitrator is unlikely to choose the less reasonable offer. In a conventional arbitration or a typical judicial process, the arbitrator is allowed to choose a value between the two figures. Although conventional arbitration may be efficient in comparison with a lengthy court process, it tends to reward unreasonableness, because the parties believe that the arbitrator will land somewhere between their offers. The more unreasonable your offer is, therefore, the better you are likely to fare.
A Primer on Final-Offer Arbitration
Final-offer arbitration—also known as “baseball arbitration” because of its use in Major League Baseball salary disputes—was first suggested in the 1960s by the labor relations scholar Carl Stevens as a strategy for driving parties to agreement. Conventional arbitration was already in frequent use as an alternative to strikes for resolving disagreements between management and labor. In conventional arbitration the two parties make their cases to a neutral third party whose ruling on the issue at stake is binding.
Essentially, conventional arbitration serves as an efficient judicial process. But research showed that parties were remaining far apart in the expectation that the arbitrator would simply split the difference between them. In that case, the more unreasonable your offer, the better you fared. Thus many people questioned the wisdom of arbitration. Stevens created final-offer arbitration to address the problem and to encourage negotiators to solve disputes on their own.
Under final-offer arbitration, reasonableness is rewarded rather than punished. The two parties submit their final offers, and the arbitrator must select one or the other. Although this may prevent the arbitrator from choosing a number he or she believes is truly fair, the riskiness of the process drives the parties toward agreement, dramatically raising settlement rates. In the rare case when arbitration is actually invoked, each party competes to be more reasonable than the other.
“The suggestion was not received with overwhelming enthusiasm by the labor-relations community,” Stevens recounted in 1976. “Indeed, there was a tendency to write it off as an unworkable ‘gimmick.’” Many people criticized the requirement that the arbitrator choose the lesser of two evils rather than what was actually fair. Nevertheless, final-offer arbitration has proved to be a strong alternative to courts and strikes.
The final-offer arbitration challenge worked because it exposed the unreasonableness of the other side’s position: The claimant’s attorney, realizing that AIG was convinced of its position and unlikely to be flexible, abruptly reduced the demand by more than half, from $2.6 million to $1.25 million. AIG reiterated its relatively fair offer of $850,000. A rapid series of offers and counteroffers ensued, and the claim was settled in a matter of days for $1.05 million.
Notice that the parties in this case ultimately avoided arbitration but did converge on a number close to AIG’s opening offer. We expect that as the challenge strategy is used more widely, this result will be common: The party subject to the challenge will quickly return to the table with a more reasonable position.
It is rational for claims executives to argue that if they make a reasonable opening offer of 90% of a claim’s true value and the other side counters with an unreasonable 1,000%, they will be poorly positioned for the usual process of exchanging concessions. The final-offer arbitration challenge curtails this process by sending a credible signal that the other side should not expect much more movement. We are confident that the challenge will often bring the other party to reasonableness.
When to Use the Challenge
Prior to this work, the use of arbitration was typically established as the default for obtaining agreement long before the actual negotiation started. That is, it was mandated if the parties couldn’t reach an agreement on their own. A unique feature of our approach is that one side in a dispute can present the final-offer arbitration challenge at any time.
We suggest that parties we are advising determine, before or during a negotiation, the range of possible settlements an objective observer would consider fair and then make a reasonable offer. If the counteroffer is unreasonable, they should ask if the other side really believes that its offer is fair. If the answer is yes, they should propose that the two offers be submitted to final-offer arbitration. If you are sure that your offer is more reasonable than the counteroffer, you can be confident of prevailing if the other side accepts the challenge. But it rarely will. The point of the challenge is to credibly signal that you believe your offer is fair and you won’t improve on it unless the other side returns to the table with a far more reasonable proposal.
The challenge strategy makes sense in any dispute where four conditions are met: You have made a reasonable offer that has been countered with an unreasonable one. You are confident of what a fair resolution would be. Escalating the dispute into litigation would be costly. Neither side can easily walk away.
What is “fair” or “reasonable” lies on a spectrum from objective to subjective and thus from clear to ambiguous. With many insurance or legal claims, historical data or records from similar cases can provide a solid basis for determining a fair settlement. The value of a new car totaled in an accident is easy to determine and hard to dispute. But personal injury claims involving emotional suffering require more-subjective evaluations. The challenge should be reserved for disputes in which the objective value of a claim is fairly clear; the more ambiguous the value, the greater the uncertainty about where an arbitrator’s decision will fall.
To determine fairness in an injury case, an insurance company could assemble several independent experts, give them the facts, and ask each to gauge the claim’s value. If their conclusions are fairly well aligned, the insurer can be confident of its offer. If a group of experts returns with widely divergent values, you know that “fair” is ambiguous—and, therefore, that using the challenge strategy will be risky.
Having established what’s fair, ask, “Can either party easily walk away?” In a typical buyer-seller transaction, if the parties’ positions are polarized and neither side is inclined to bargain, a final-offer arbitration challenge isn’t useful, because the other side can simply abandon the negotiation. In a legal dispute, however, where walking away isn’t an option, the strategy can make sense.
This approach is most applicable to resolving disputes, but we can also imagine how it might help close a deal. For example, it could be used to break an impasse in a merger negotiation when the parties have agreed to all but one of the deal’s components. Rather than allow the negotiation to collapse over one small dispute, the parties could subject the lone contested element to final-offer arbitration, potentially preserving the merger.
Saving the Deal
Consider how the final-offer arbitration challenge might be used to rescue a merger negotiation when the parties are close to an acquisition price. The target firm wishes to reach agreement quickly to avoid a hostile takeover attempt by a different company. The target and the acquirer are only $30 million apart—a small percentage of the roughly $800 million price. The disagreement is over the valuation of one piece of the business: a new project about which the target, unlike the acquirer, is enthusiastic. There is not enough time to extract this project from the deal—for example, by selling it off as a separate company.
Either side could propose moving forward with the agreement while quickly setting up final-offer arbitration to determine whose valuation of the project is fairer. We predict that such a proposal would result in a negotiated agreement, making the arbitration unnecessary. And if either side was bluffing about its valuation of the new project, the final-offer arbitration challenge should bring it back to the table in a more concessionary mood.
Building Your Reputation
The obvious benefit of employing this strategy is economic: A more efficient negotiation is a lower-cost negotiation. But the strategy potentially has another, less obvious benefit—enhancing a company’s reputation for fairness. That was one of Peter Hancock’s goals. Several considerations are relevant when using the strategy to this end.
We recommend that you begin a negotiation with a reasonable offer—to the extent that you have a good assessment of what is fair—and that you do so before an unreasonable one is put on the table. This flies in the face of much conventional wisdom, but it will strengthen the reputational signal you’re trying to send. (It will also leverage the anchoring effect, steering the other side toward reasonableness from the start.) In a more typical negotiation, both parties open with unreasonable positions and only later move to a reasonable stance. But if the goal is to signal fairness, beginning the dysfunctional dance will work against you.
We discourage use of the challenge when both sides are being unreasonable. Although you may win the dispute, you won’t have improved your reputation—and you may have diminished it. Furthermore, it’s highly uncertain what an arbitrator faced with two unreasonable offers will decide.
Companies interested in using the final-offer arbitration challenge will most likely pilot it. If that goes well, they may choose to roll it out more widely. Adding the challenge strategy to a tool kit requires developing new negotiation skills and may mean leading a significant organizational culture change. As noted, opening a negotiation with their most reasonable position is anathema to many practitioners.
Let’s look first at the technical part—learning new skills. In most companies where some negotiation ability is required, basic soft skills—such as how to read the other side or find opportunities for joint gain—are commonly taught. But companies rarely teach the negotiation analytics skills that business schools do. A company planning to use our strategy must train its negotiators to objectively assess fairness—including how to conduct formal analysis on the basis of previous negotiations and how to aggregate assessments from multiple experts. And, of course, negotiators must learn the mechanics of issuing the final-offer arbitration challenge. They need to be instructed in the legal logistics of setting up the process, local arbitration laws in countries around the world, and how to access arbitrators through organizations such as the American Arbitration Association.
These methods have been disseminated across AIG through an international training program we devised for many hundreds of adjusters involved in claims worth tens of billions of dollars. An important part of the training has been to teach skeptical adjusters the logic of abandoning negotiation tactics they’ve long found natural. Getting buy-in for the new approach, which puts being fair first, is essential.
The leadership challenge can’t be overemphasized. Although leaders at the highest level may see an argument for change, those further down in the managerial ranks may push back against doing some things very differently. Actively creating a supportive environment means rewarding negotiators for using the strategy—and not punishing them for negative outcomes.
Suppose a claims adjuster proposes final-offer arbitration and his company loses. That’s not necessarily a bad thing; the company shouldn’t expect to win every case that goes to arbitration. Consistent success might suggest that the company tends to make overly generous offers. However, if the gap between the competing offers was large and the company’s negotiator lost, he or she may have misjudged what constituted a reasonable offer. To reduce the danger of such misjudgments, we propose that a broader team, including the negotiator’s manager, review the offer in advance. When a bad outcome suggests a misjudgment, the company—not an individual negotiator—should own the decision.
Above all, it’s critical that endorsement of the program at the highest level be visible throughout the organization. At AIG materials for the training program were conspicuously branded “The AIG Way of Negotiating,” and Hancock publicly emphasized both the reduced litigation costs and the reputational benefits he hoped would result.
We encourage negotiators to use the final-offer arbitration challenge not as a hostile act but as a civil mechanism for signaling an honest belief in the fairness of their offers. Fully implementing the strategy requires leadership commitment and investments in training. But if it reduces costs, improves customer satisfaction, and boosts your reputation, the investment is sure to be worthwhile.
Max H. Bazerman is the Jesse Isidor Straus Professor of Business Administration at Harvard Business School and a codirector of the Center for Public Leadership at Harvard Kennedy School.
Daniel Kahneman is a professor of psychology and public affairs emeritus at the Woodrow Wilson School and the Eugene Higgins Professor of Psychology Emeritus at Princeton University. He was awarded the Nobel Prize in Economic Sciences in 2002 for his work (with Amos Tversky) on cognitive biases.
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