Understanding Insurance Markets.

• Author: Murray, Phil R.

Risky Business: Why Insurance Markets Fail and What to Do About It

By Liran Einav, Amy Finkelstein, and Ray Fisman

271 pp.; Yale University Press, 2022

Readers who enjoy learning how markets work will appreciate the new book Risky Business by Liran Einav (Stanford), Amy Finkelstein (MIT), and Ray Fisman (Boston University). The authors explain that insurance markets are "selection markets" in which firms face different costs for providing their good or service depending on who the buyer is. Some buyers are high cost while others are low cost. The problem is that the buyers know whether they will be higher- or lower-cost, but the sellers do not readily know.

When the 2010 Affordable Care Act's insurance mandate was before the Supreme Court, Justice Antonin Scalia asked, "If a paternalistic government could force people to buy health insurance, could it also force people to buy broccoli?" Astounded that Scalia seemingly did not understand the difference between a selection market good and an ordinary good, the authors declare, "That was the moment we realized we had to write this book."

Adverse selection / Selection markets are precarious. Einav, Finkelstein, and Fisman illustrate this with a non-insurance product: AAirpass, which American Airlines rolled out in 1981. Buyers paid $250,000 for "unlimited first-class travel for life." Management underestimated the enthusiasm some buyers would have for flying. Some buyers arranged multiple-city trips. Some flew to international destinations and back every other day. To stem the losses, American increased the price to $1 million. This made matters worse, as many lower-cost buyers dropped out of the market while higher-cost buyers remained. The moral of the story is that "the customers who are willing to pay the most are sometimes the ones you want the least." American held out for a while but quit selling AAirpasses in 1994.

In contrast to the AAirpass, divorce insurance failed quickly. The authors tell the story of John Logan, who offered a policy called WedLock. Einav, Finkelstein, and Fisman identify two selection problems: couples who know their marriage is doomed--a classic "adverse selection" scenario--and schemers who plan to divorce. Logan attempted to avoid those problems by including a waiting period before a claim could be filed; as the authors note, "Waiting periods are a common technique that insurers employ to deal with selection." WedLock charged a premium of $1,900 per year, with the earliest payoff of $ 12,500 after four years. The payoff would rise by $2,500 per year so long as the policyholder continued to pay the...