Insurance As Signal

Barbara Kiviat in Time:

There are higher-yielding varieties of groundnut than those that farmers in Malawi tend to plant, but getting them to switch is tough. Better seed is pricey, increasing their risk. So researchers from the World Bank ran an experiment. With local NGOs, they offered the farmers loans. Some loans even came with a crop-insurance policy: if the season was dry and the yield a dud, the debt would be forgiven. The farmers’ risk was lowered. Of farmers offered conventional loans, 33% signed up. With the added incentive of insurance, 18% did. The researchers were puzzled.

It’s been more than 30 years since microfinance began its fantastic rise, spreading billions of dollars in credit to hundreds of millions of overlooked borrowers around the world. Insurance is the next big promise of financial services for the poor.  But there aren’t many takers.  That’s not from lack of interest on the part of suppliers. The Gates Foundation has plowed millions of dollars into microinsurance initiatives …

In Portfolios of the Poor, New York University economist Jonathan Morduch and his co-authors toss out other reasons microinsurance may be a hard sell. First, being poor is not without complications, and that’s part of what makes a loan attractive. Sure, microcredit is typically meant to help build a business, but cash is fungible–if there’s no money for dinner one night, a line of credit, whatever its intent, solves the problem. Not so for insurance, which asks people to decide in advance which of the many risks they face they should hedge. Plus, even without formal insurance, most people already have some version of a safety net: friends, family and–in truly catastrophic situations–government. …

There is also a much more basic explanation for why insurance doesn’t sell. Insurance has proved its worth for centuries, but people still resist it. They don’t like thinking about the possibility of bad things happening. That’s why car insurance is mandatory–and health insurance may soon be. If supposedly financially sophisticated Americans have to be coerced to buy insurance, should we really expect people in less rich countries to be any different?

Why do people buy insurance?  The very solid economic theory of risk-aversion explains why insurance is a good idea, but I don’t believe this explains most of our insurance behavior.   In class discussions, my students seem completely uninterested in insuring most of the biggest risks they face, such failed marriages or careers, even if various practical problems could be overcome.

Yes, we don’t like thinking of bad things happening to us, but even so many of us do voluntarily buy insurance.  So why are we uninterested in insuring our biggest risks, but do occasionally insure a few risks?

My best guess is that most insurance is bought not to reduce risk but instead to signal prudence and caring.  The first life insurance companies had a terrible time selling “bets on their death,” and only succeded when they framed insurance as what a caring and prudent husband and father did to take care of his family.  While simple adverse-selection theories predict that high risk folks buy the most insurance, in fact low risk folks buy more insurance. And we don’t want to insure our big life risks because such a desire would signal a lack of confidence in our prospects.

Poor folks want loans because they want the money, but to want insurance they’ll have to want to signal prudence and caring, above and beyond the signals they now use.  Seems a hard sell to me.

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  • Grant

    Without knowing the cost of crop-insurance, how can we say why fewer Malawis purchase it? I suppose there is also a possibility that other financial instruments can be used to hedge against crop failure.

    There are so many ways to market many insurance policies as responsible purchases that I’m generally skeptical of arguments claiming they are under-purchased due to signaling.

    Career insurance may be problematic because of simple incentives. People might be inclined to put on a good show, purchase the insurance and then slack off. Though I agree purchasing career or marriage insurance likely seems ‘weird’ or ‘silly’ to most people.

    Now what about child birth or raising insurance?

    • I read them as saying the added insurance was free.

      • Joe Teicher

        If the insurance was really free then the farmer’s behavior is pretty weird, isn’t it? I have one hypothesis that would explain it. What the NGOs were offering was basically a guarantee on the seed. When a for-profit company provides a free guarantee you should lower your subjective probability that the product will fail, because you expect that they don’t want to pay a lot. However, when a charity offers a guarantee it might make sense to raise your subjective probability of failure because you think that the charity workers are worried about your interests. If the farmers thought that the NGOs thought that the new higher-yielding crop had a higher probability of failure, they might not want to plant it even with a loan guarantee because presumably a crop failure would still be costly for them.

      • Grant

        This looks like the paper the article was based on, which says the insurance was priced “fairly”, and was actually based on rainfall:

        Though I’m not that familiar with academia, I oddly found two different abstracts for this paper. Each had a different explanation for why the farmers did not take the insurance:

        There is suggestive evidence that the reduced take-up of the insured loan was due to the high cognitive cost of evaluating the insurance: insured loan take-up was positively correlated with farmer education levels. By contrast, the take-up of the uninsured loan was uncorrelated with farmer education.

        There is suggestive evidence that reduced take-up of the insured loan was due to farmers already having implicit insurance from the limited liability clause in the loan contract: insured loan take-up was positively correlated with farmer education, income, and wealth, which may proxy for the individual’s default costs. By contrast, take-up of the uninsured loan was uncorrelated with these farmer characteristics.

        Of course these explanations don’t rule out signaling incentives, but it hardly seems obvious to me that signaling is the major cause here.

  • Grant

    Also, crop-insurance would seem to have some serious systemic risks. Aren’t widespread crop failures often the result of the weather? So anyone insuring farms in such a manner would need to be well diversified, or investment in their insurance could be very risky.

    • anon

      “Aren’t widespread crop failures often the result of the weather? So anyone insuring farms in such a manner would need to be well diversified, or investment in their insurance could be very risky.”

      No, the weather is mostly uncorrelated with the market portfolio. So adding insurance to an investment portfolio will *decrease* risk, as long as the probability of severe weather is correctly ascertained.

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  • Nithya

    Re: risk of failed marriages, many people consider pre-nups as some sort of harbinger of doom so the idea of formal insurance may seem a further step in the wrong direction. In that instance, is it possible that a failure to insure against such a risk is itself a countersignal as to the inherent faith one has in her relationship, thereby explaining the consequent disregard for prudence?

  • Michael Turner

    “Seems a hard sell to me.” Indeed. Especially the part about showing prudence and caring “beyond the signals they now use.” Buying insurance might be seen in these societies as substituting cold hard cash for a sincere affective signal. Actually, in a traditional society with habits of mutual aid, or of suffering in solidarity when mutual aid is no longer possible (as in severe droughts, perhaps), buying insurance might signal prudence and caring only for yourself and your immediate family, and would thus be a departure from the social default, it would be a signal of a desire to decouple from community solidarity. The solution might be to sell collective insurance packages to whole farming communities. However, that takes you into free-rider territory and into governance issues that might be even more difficult.

  • a theory of insurance would also have to the explain the mystifying popularity of buying insurance against trivial, frequent and predictable mishaps, such as breakdown of electrical appliances and loss of mobile phones, illness of pets etc.

    Extended warranties (as they are know in the UK at least) are startlngly big business – I saw a £200 laptop last week with the offer of a £100 extended warranty (!). Why are people so willing to spend large sums on trivial, frequent events. It must be obvious that over 5 years you would be extrememely fortunate (or unforunate?) to collect more in claims than you have spent in premiums.

    • anon

      One theory is that manufacturers should subsidize extended warranties as a signal of product reliability. If nobody ever buys extended warranties, it is much easier for them to decrease the quality of their products by using cheaper components and poorer QA.

      • A plausible theory in the abstract, but in tension with the fact that Consumer Reports and other consumer advisers recommend against buying such insurance.

    • ES

      The explanation is pretty trivial: it lets the retailer extract some extra consumer surplus from people who don’t care or don’t have the math skills to figure out whether it’s a waste of money.

      • yes, but why is it that consumers fail to buy enough catastrophic insurance, but overspend on insuring against common everyday eventualities.

        Robin suggests that people don’t like to contemplate bad things happening, so underinsure…

        Perhaps it’s just the marketing. Perhaps if you could buy $100 life-insusrance tokens at the checkout – good for 10 years, pay $10,000, standardised policy terms, then people wd buy more of it. It’s all that going to see a financial advisor stuff that puts people off.

  • jonathan

    My reading of the experiment is that the farmers were individually offered loans, some with and some without insurance. It may simply be the ones offered “with” then drew the typical inappropriate dots and thought they were paying for something beyond what they needed. They thus may have thought they were paying too much even if the price was actually the same as what others paid. In other words, the list of options present in a purchase gives context to value and here it may have signaled – unwittingly – that insurance had a price and that price was built into the loan. People are terrible at taking things out of the context in which they’re displayed.

  • Rachel

    There’s a really obvious explanation of why the farmers didn’t want the insurance. They weren’t planning to pay back the loan if the crop failed, even if the contract said they should. So the “insurance” product was just charging higher prices in the one state of the world where they planned to pay back the loan. Unlike local money-lenders, the NGO couldn’t really punish them for defaulting on the loan.
    When bankruptcy is an option, insurance often lowers the mean return without reducing variance. So its clearly a pointless product for people near the edge.

  • dWj

    > car insurance is mandatory–and health insurance may soon be

    Indeed, it seems to me we may well be forcing health insurance on people as a way to signal that “we” care about them, more than because it’s actually an efficient way to reach a desirable outcome.

  • Re: “Why do people buy insurance? The very solid economic theory of risk-aversion explains why insurance is a good idea”

    What that theory says is that you should only insure what you can’t cover – cases where you have inside knowledge about your risk – and what you are legally obliged to insure.

  • Doug S.

    Only liability car insurance is mandatory. If you were to injure someone else or damage their property with your car, you have to be able to pay for the damage – and the damage can easily be more than most people are able to pay. Insuring against damage to yourself and your own property is not mandatory.

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