April 27, 2023 by Alyssa DiSabatino
Of all the adjectives you could use to describe the insurance sector, sexy may not be the first you’d think of.
But the industry provides a “measure of certainty in a dangerous and uncertain world,” and that can be quite alluring, M.I.T economist Amy Finkelstein told the Freakonomics Radio Book Club podcast.
While many see insurance markets as broken, she said consumers and sellers can do something about it.
“Insurance is one of those topics that makes the average person’s eyes just glaze over. Did you used to be like that before you fell in love with insurance?” asked Freakonomics host and journalist Stephen Dubner.
“Probably yes, because I fell in love with it for a very particular reason…” said Finkelstein, who was exposed to the industry while serving as a junior staffer on the Council of Economic Advisors. “When I looked back at…the things that really excited me, I had gotten to work on natural-disaster insurance, on automobile insurance, on unemployment insurance. The common denominator, it turned out, was insurance.
“But one thing I hadn’t realized ’til I started working in economics is there’s another type of market frailty that’s really important, that’s the subject of a lot of government policy, but that most people just don’t seem to be as aware of. And that’s the problem of selection. And it’s front and centre in insurance markets.”
Dubner described selection as a cat-and-mouse game, where insurance companies try to pick the low-risk customers, while the high-risk customers try to persuade the insurers they’re low-risk.
Adverse selection in the insurance industry happens when an applicant gets insurance at a cost that is below their true level of risk.
The problem of selection, she said, is that “customers know stuff about how likely they are to need payouts on their insurance, and the ones who know that they’re more likely to need it flock to the market and destroy it for the rest of us.”
But how can the industry solve this issue of selection?
“What to do about it depends on who you are,” she said. “If you’re the customer, I have several suggestions for what to do about it. They’re different than if you’re the seller or if you’re the government.”
If consumers understood the problem of selection, they’d also realize how to get a good deal — through deductibles.
When she was insuring her home, Finkelstein signed a policy with the largest deductible she could find, saving her some money on rates. Then her house was hit by several storms in succession.
But “even despite those two really expensive events that we had to pay a lot for because we had this huge deductible, we still have ended up saving money because the premiums are so much lower because they’re priced for lower-risk people,” she said.
Sellers, meanwhile, can address the selection problem by thinking about how to design policies to attract the kinds of customers they want.
For example, health insurers bundle discounts for gym memberships with health insurance coverage.
“The reason employers offer workplace wellness programs, and the reason health insurers offer you a discounted or free gym membership is not because they’re hoping to make you healthier; it’s because they’re hoping to attract the customer for whom that’s appealing…the healthy and spry customer who at least can delude themselves into thinking, yeah, they’re really going to go to the gym.”
Feature image by iStock.com/Mohamad Faizal Bin Ramli