Across the United States, about three-quarters of people enrolled in Medicare Advantage plans—a form of private insurance that follows Medicare rules—receive free gym memberships. why is that?
The answer, the research has shown, is that it improves the insurance companies’ customer base: The promise of free workout time lures not only existing clients from the couch to the gym, but new, healthier-than-average clients. For insurance companies, this is important. When their customers are healthier, insurance companies pay fewer claims and earn higher profits.
“What you see in the data is that these programs actually attract people who are in better health,” says MIT economist Amy Finkelstein, an insurance researcher. “Things like mobility, energy level, or pain are very difficult for an insurance company to monitor about a potential client. If you want clients who are in better physical shape, in addition to what you can observe about them, finding people who want to go to the gym , and who find it attractive, it’s a very nice way to get to know these new customers.”
In contrast, the entire insurance industry revolves around a struggle over the types of clients you attract. People want insurance in case something goes wrong. But insurance companies want customers who rarely need surgery, auto repairs, or slip their homes into the ocean. This makes insurance a distinct industry.
After all, neither a supermarket chain nor a car dealership cares excessively about who buys their products, as long as sales are sufficient. But for the insurer, getting this problem right makes the business viable, while getting it wrong leads to companies and markets crashing. Attracting too many needy clients, from the insurance company’s perspective, is the “adverse selection” problem in the business
“Your insurance company cares a lot about which customers buy their products,” says Finkelstein. “Because the insurance company’s profits depend not only on how much they sell, but to whom they sell to.”
Finkelstein, the John and Jenny S. McDonald Professor of Economics in MIT’s Department of Economics, co-authored a new book on the subject, Risky Business: Why Insurance Markets Fail and What to Do About It, published today by Yale University. He presses. It was written with Liran Enaff, Professor of Economics at Stanford University, and Ray Fisman, Professor of Economics at Boston University.
Everywhere we look, it’s a matter of negative selection
Finkelstein is a leading researcher in the field of health insurance and has collaborated with Einav frequently on research papers on this topic. However, “risky business” covers many types of insurance—life, auto, dental, and more. In all of these areas, companies do their best to avoid adverse selection, which explains many of the insurance’s frustrating or quirky features.
For example: Why do health insurance companies have an “open enrollment” period that only lasts a few weeks a year? Why is dental insurance “appallingly inadequate,” the authors write in the book? If you sign up for auto or life insurance, why is there a waiting period before your policy becomes effective? Why do auto insurance companies care about your GPA?
In each case, the answer involves choice. Open enrollment periods exist so that people do not wait until they have a specific medical diagnosis before choosing their own 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.
This might sound like exactly how insurance should work for consumers: Sign up for what you need, and get compensated. However, the purpose of insurance as a system is to provide a buffer against the vicissitudes of fate. If people wait until things are bad to sign up for insurance, a vicious spiral could result. When enough consumers need assistance and payments increase, premiums go up and insurance becomes prohibitively expensive. Businesses and industrial sectors could collapse in the meantime.
“One of the biggest problems with adverse selection is that it can make the market disappear completely,” says Finkelstein.
This is also why there are waiting periods for insurance—often two years for life insurance, or a week for auto insurance. As the book tells, when Finkelstein’s husband—MIT economist Ben Olken—was in graduate school, his car broke down. Waiting for AAA on the shoulder of the road, he calls to upgrade his car insurance so that it covers the long distance he now wants. To his delight, Olkin is told he can increase his coverage. To his dismay, he was then informed that the new policy would not start for a week. Blame it on negative selection.
“We’re trying to show that there’s a common idea behind a lot of the things out there in the world,” says Finkelstein.
In fact, auto insurance companies want to know potential clients’ academic records because, for whatever reason, people who are more successful in school file fewer auto insurance claims. And from time to time, companies are discovering new ways — like gym membership offers — to build their base of consumers who rarely need insurance.
As “risky business” also appears, it took insurance companies some time to get to this point. In the late 17th century, Edmund Halley, better known for the comet that bears his name, used German census records to develop the first systematic method for pricing annuities, a type of insurance guaranteeing an annuity until death. However, it was not a viable system, precisely because Haley had not considered the opposite choice.
For all that insurance companies know about people in the age of big data, the industry still lacks everything. Research has shown that people who take out life insurance are more likely to die at a younger age. But it is not clear why, based on available health measures.
“We still don’t really know what people know, but life insurance companies can’t figure it out,” says Finkelstein.
As the authors explain in the book, negative selection leaves policymakers in a bind. Making health insurance the same price for everyone, even for those with notable problems, might seem fair and equitable. But the numbers may not fit insurers, as evidenced by the collapse of state-backed health insurance exchanges in New Jersey and New York that required all customers to charge the same rate.
“On the one hand it was more equitable, since no one was treated differently, but everyone was underinsured,” Finkelstein notes. “We need to understand those trade-offs and make more informed decisions.”
The Affordable Care Act is known to have addressed adverse selection by requiring everyone—even the healthy—to have health insurance, while providing subsidies for people to enroll. This approach has been the subject of much controversy, but it acknowledges the central tension of insurance.
“Sometimes even getting politics right isn’t about perfecting the world, but figuring out how to balance different kinds of problems,” says Finkelstein.
Experts praised Risky Business and its approach to explaining insurance markets. “The very human cat-and-mouse stories that move,” says Nobel Prize-winning economist Georg Akerlof, Ph.D. ’66.risky business’ Not just great fun; They also subtly reveal the foundations of a great deal of economics.”
For her part, Finkelstein hopes that the book will interest a broad audience of readers who, whether satisfied or disappointed with their insurance, will at least have the satisfaction of understanding why the entire industry exists in its current form and practices.
“We see our role in helping people understand the world around them a little better,” she says.