Solving the Add-On Insurance Dilemma
Informed observers have long marveled at the high prices charged for low value insurance products sold as “add-ons” to consumers buying other products. Examples include the extended warranties sold with electronics, the credit life insurance sold with auto loans, and the collision damage waivers sold with car rentals. Unlike iPhones, there is nothing obviously cool or distinctive about add-on insurance products. They are just contingent claims on money that protect consumers from losses that are easy to predict in the aggregate and should sell at prices that are close to insurers’ predicted costs. Yet, sellers are able to charge prices for add-on insurance that greatly exceed the cost of providing it.
Regulators have long suspected that these high profits reveal something awry in the sale of insurance add-ons. Investigations of credit life insurance in the 1950’s, collision damage waivers in the 1980’s, and extended warranties in recent years documented the excess profits earned on the sale of these insurance products, along with the abusive sales practices that such profits induce. Yet, regulators have struggled to identify how these excess profits are sustained. Indeed, an otherwise impressive study
by the U.K.’s Competition Commission
attributes excess profits earned on the sale of extended warranties for consumer electronics to an ill-defined “complex monopoly situation” that the study never really explains. Not surprisingly, the Commission’s solution – a set of information forcing measures adopted in 2005 – has not worked.
The conceptual problem for the Competition Commission, state insurance departments, and most other consumer protection agencies that have examined add-on insurance markets can be traced to the economic model they use. The add-on insurance product market quite literally “does not compute” within the standard Insurance Economics 101 framework that has traditionally informed regulation. Add-on insurance poses two main conceptual problems for the standard analysis. First, a robust market for these kinds of insurance should not even exist. Expected utility theory teaches, unequivocally, that people should not buy insurance for low-value losses. Second, even if it did make sense for people to buy add-on insurance, the market should not in the long run permit sellers to charge prices that greatly exceed costs.
The problem is not with economics, but rather with the failure of insurance regulation to move beyond Economics 101. Behavioral economic analysis has addressed both of these conceptual problems. First, borrowing from psychological research, behavioral economics explains why people buy insurance for small losses, even at prices that greatly exceed cost. Second, using a simple equilibrium model (shrouded pricing), behavioral economics explains why prices for add-on insurance so often greatly exceed cost, even when sellers operate in a competitive market for the primary product to which the insurance products are add-ons.
In our new working paper, “Protecting Consumers from Add-On Insurance Products: New Lessons for Insurance Regulation from Behavioral Economics
,” we discuss the implications of this analysis for insurance regulation, exploring four possible strategies: (1) improved disclosure of the terms of add-on insurance products; (2) a ban on the sale of the products as an add-on; (3) price regulation; and (4) the use of information technology to create a robust market at the point of sale. Drawing from recent U.K. experience, we recommend a mixed approach for the three specific products we examine: a ban on the sale of credit life insurance and extended warranties as add-ons, plus a new, online market for car rental insurance that customers can access at the car rental desk.
It is important to emphasize that we are not merely adding together two disparate strands of behavioral economics. We combine the shrouded pricing model with the behavioral economics of low-value insurance to yield a key insight into the welfare analysis of this market that is not present in either story by itself. The shrouded pricing model explains in general terms how supra-competitive prices for second-stage or supplemental products, like razor blades or toner cartridges for laser printers, can be maintained in equilibrium. In these cases, the second stage product is an appropriate—or even necessary—complement to the first stage product: razor blades and toner cartridges have finite lives, and razors or printers are useless without them. Consumers may have a choice among competing second-stage products, but they cannot avoid purchasing any second-stage product at all.
That relationship is decidedly not the case when the second-stage product is add-on insurance, whose purchase is irrational to begin with. The option not to buy at all is not only real, it is compelling—at least to rational consumers. That option means that sellers must undertake efforts to convince customers to buy the add-on insurance product. Moreover, such efforts are highly profitable, which implies that all kinds of hard-sell tactics are virtually compulsory because the marginal return to a dollar spent on inducing a customer to purchase add-on insurance is high.
Our paper outlines a more activist approach than even the most forward-thinking insurance regulators have entertained in recent years, but new science and a new regulatory environment supports our proposal. The new science is behavioral economics. The new regulatory environment is a response to the financial crisis of 2008. State insurance regulators successfully argued for the exemption of insurance products from the jurisdiction of the new Consumer Financial Protection Bureau, on the grounds that they already were looking out for consumers and that state-based regulation allowed for innovation and experimentation. Add-on insurance products present an excellent opportunity to test that claim.