Risky business: why insurance markets fail and what to do about it
by Liran Einav, Amy Finkelstein, and Ray Fisman, Yale University Press, 2023
What’s going on with the insurance markets? Why are policies so expensive and full of exceptions? Why do insurance companies have a bad reputation when it comes to claims settlement? These are frustrating questions because the principle behind insurance is simple and the benefits are obvious: Occasionally something unlikely but potentially ruinous happens in life. Because nobody can be expected to live life to the fullest and be prepared for every possible eventuality, insurance companies spread the risk across a large group of people.
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According to Risky Business, a gem of a book by three academics Liran Einav, Amy Finkelstein and Ray Fisman, there’s a very simple reason why insurance is so annoying. At its core, insurance is all about what economists call selection markets. Insurance markets are selection markets because not all customers are the same: insurers want customers who pay their premiums and rarely report claims, and they don’t want customers who regularly use their policies for expensive work. Customers, on the other hand, want to choose from a range of policies at reasonable prices.
The authors’ first example of the problems of selection markets is also their best. In 1981, American Airlines offered its customers free first-class travel for a lifetime for an upfront fee. The airline figured the offer would attract business travelers. It never occurred to the company that some people really like to fly for fun. Servicing these leisure travelers proved very expensive due to the frequency of their travel, so American increased the price of the plan. After several more rounds of price increases, the company finally withdrew the offer in 1994. “Americans have learned the hard way that sometimes the customers who are willing to pay the most are the ones they want the least,” the authors explain. The selection market had collapsed.
Keeping selection markets afloat is proving to be a stubborn problem. The key is information. Customers know things about themselves – like their love of luxury flying, aspects of their medical history, or their confidence as a driver – that would influence the insurer’s willingness to enroll them. And customers will always try to get the best out of their policies. The authors highlight research by health economist Marika Cabral, which showed that when customers of a dental plan offered by a private company were offered the option to upgrade to a new plan with a higher benefit cap, the value of claims increased by 60%. in the month after the change.
Insurers have tried various strategies to mitigate the disadvantage of asymmetric information. Below are holes in the cover. Life and auto insurance policies often include waiting periods to prevent customers from signing up just to make an immediate claim. Or there will be more subtle nudges to get the “right” customers to join, such as: B. Health insurance companies that offer discounted gym memberships. Intriguingly, a study of life insurance customers found that those who enrolled in and were offered access to a wellness program did not benefit from a health perspective versus those who did not; they were fitter from the start.
A study of life insurance customers found that those who enrolled in and were offered access to a wellness program did not benefit from a health perspective versus those who did not; they were fitter from the start.
Even as the amount of information available to insurers increases (and insurers have become much more sophisticated than they used to be at collecting and analyzing data), customers still seem to have a better sense of their own future. Another study cited by the authors compared two groups of older adults who were comparable in every category important to life insurers, including health status and preferred hobbies. During the 12 years of the study, deceased participants were 20% more likely to have had life insurance. Here the problem becomes inexplicable. The authors admit they are baffled “by what information that is both relevant to their chances of survival and not on the application they can keep to themselves.”
But – and this is what makes selection markets so puzzling – the authors argue convincingly that customers should not strive for a complete exchange of information either. Although insurers are keen to know as much as possible about their potential customers, they often refrain from asking questions that they are legally allowed to ask. If insurers knew a customer came from a family with a chronic medical history, they might choose not to insure them altogether. Or, as the authors put it, perfect information would “destroy people’s ability to insure (or become) against a bad risk, which is the reason for being able to insure at all.
In an excellent section, the authors point to a 2020 New York Times article that uses a specific case to rail against Medicare Advantage, the system that offers private insurance subsidies for older Americans. At 65, a healthy man took out a “light” policy with low premiums. Seven years later he was diagnosed with cancer, treatment for which was not covered by his policy. He found he could not switch politics, a decision the newspaper criticizes. Reading the article, one can easily feel that the customer was treated unfairly. But for the authors, his case reveals a common misconception about insurance that “one should buy…to insure against a possible event or risk, not to pay for that eventuality after it has happened.” It takes some guts to argue that a sick, elderly man shouldn’t be entitled to more comprehensive health care, and it also takes skill not to come across as a cold-hearted, gloomy scientist, but these writers pull it off. As an introduction to how a seemingly simple industry is actually complicated as hell, Risky Business makes an excellent read.
Author Profile: Mike Jakeman is a freelance journalist and has previously worked for PwC and the Economist Intelligence Unit. Share on: Topics: economy, insurance, insurance companies, risk, risk management
