In the United States, about three-quarters of people enrolled in Medicare Advantage plans — a form of private insurance under Medicare rules — receive free gym memberships. Why is it?
The answer, according to research, is that it improves insurers’ customer base: the promise of free workout time doesn’t attract existing customers from the couch to the gym, but it attracts new, healthier customers than the average. For insurance companies, this is important. When their customers are healthier, insurers pay fewer claims and earn higher profits.
“What you see in the data is that these programs actually attract healthier people,” says MIT economist Amy Finkelstein, an insurance specialist. “Things like mobility, energy level or pain are very difficult for an insurer to observe in a potential client. If you want clients who are more physically fit, beyond what you can observe about them, finding people who want to go to a gym, who see that as attractive, is a really nice way to identify those new customers.
In turn, the entire insurance industry revolves around a struggle over the types of customers it attracts. People want insurance in case something goes wrong. But insurers want customers who rarely need surgery or auto repairs or watch their homes slide into the ocean. This makes insurance a separate industry.
After all, a supermarket chain or car dealership doesn’t really care who buys their products, as long as there are enough sales. But for an insurance company, solving this problem makes the business viable, while getting it wrong bends businesses and markets. Attracting too many needy customers, from the perspective of the insurer, is the problem of “adverse selection” in business
“Your insurer cares a lot about the customers who buy their products,” says Finkelstein. “Because the insurer’s profits depend not just on how much they sell, but to whom they sell.”
Finkelstein, John and Jennie S. MacDonald Professor of Economics in MIT’s Department of Economics, has co-authored a new book on the subject, “Risky Business: Why Insurance Markets Fail and What to Do about It,” released today. today by Yale University Press. It is written with Liran Einav, professor of economics at Stanford University, and Ray Fisman, professor of economics at Boston University.
Everywhere we look, the question of adverse selection
Finkelstein is a leading specialist in health insurance and has often collaborated with Einav on research articles on this subject. However, “Risky Business” covers many types of insurance – life, car, dental, etc. In all of these areas, companies go to great lengths to avoid adverse selection, which explains many frustrating or bizarre characteristics of insurance.
For example: Why do health insurance companies have an “open enrollment” period that only lasts a few weeks a year? Why is dental insurance “woefully inadequate,” as the authors write in the book? If you buy auto or life insurance, why is there a waiting period before your policy takes effect? Why would car insurers care about your GPA?
Either way, the answer is selection. Open membership periods exist so that people do not wait to have a precise medical diagnosis to choose their insurance. When it comes to dental insurance, studies show that people are very aware of their dental needs and try to wait until they need more dental care before upgrading their plan.
That might sound like exactly how insurance should work for consumers: sign up for what you need, get your money back. However, the purpose of insurance as a system is to provide a buffer against the vagaries of fate. If people wait for things to go wrong to buy insurance, it can create a downward spiral. When enough consumers need help and payments go up, premiums go up and insurance can become unaffordable. In the meantime, companies and industrial sectors may collapse.
“One of the biggest problems with adverse selection is that it can completely wipe out a market,” says Finkelstein.
This is also the reason why there are waiting periods for insurance, often two years for life insurance or one week for car insurance. As the book recounts, when Finkelstein’s husband – MIT economist Ben Olken – was in college, his car broke down. While waiting for AAA to arrive on the shoulder of the road, he called to upgrade his car insurance to cover the long distance towing he now wanted. Much to his delight, Olken was told he could increase his coverage. Much to his dismay, he was then informed that the new policy would not begin for another week. Blame the opposing selection.
“We’re trying to show that there’s a common theme behind a lot of things out there in the world,” Finkelstein says.
This is because car insurers want to know the school records of potential customers because, for some reason, people who do better in school file fewer car insurance claims. And every once in a while, companies find new ways — like gym membership deals — to build up their base of consumers who rarely need insurance.
As “Risky Business” also shows, it took time for insurers to get there. In the late 17th century, Edmond Halley, best known for the comet that bears his name, used German census records to develop the first systematic method of pricing annuities, a type of insurance that guaranteed an annual payment up to at death. It was not a viable system, however, precisely because Halley had not considered adverse selection.
Despite all that insurers know about people in the age of big data, the industry still doesn’t have it all figured out. People who buy life insurance, research shows, are more likely to die younger. But it’s unclear why, based on available health metrics.
“We still don’t really know what people know, but their life insurers can’t figure it out,” Finkelstein says.
As the authors detail in the book, adverse selection leaves decision makers in a bind. Making health insurance the same price for everyone, even those with observable problems, may seem fair and equitable. But the numbers may not add up for insurers, as shown by the collapse of state-backed health insurance exchanges in New Jersey and New York, which required all customers to be billed the same price. .
“In a way, it was fairer, in that no one was treated differently, but everyone suffered from insecurity,” Finkelstein observes. “We need to understand these trade-offs and make more informed decisions.”
The Affordable Care Act famously addressed adverse selection by requiring everyone – even healthy people – to get health insurance, while offering subsidies for people to enroll. This approach has been the subject of much debate, but it recognizes the central tension of insurance.
“Sometimes even having the right policy isn’t about making the world perfect, it’s about deciding how to balance different kinds of issues,” Finkelstein says.
Experts have praised “Risky Business” and its approach to explaining insurance markets. Nobel Prize-winning economist George Akerlof PhD ’66 says: ‘The very human stories of cat and mouse that drive’Risky business’ are not only great fun; they also subtly reveal the basis of much of the economy.
For his part, Finkelstein hopes the book will appeal to a wide audience of readers who, whether satisfied or frustrated with their self-assurance, will at least be satisfied with understanding why the entire industry has its current form and practices.
“We see our role as helping people better understand the world around them,” she says.