Liran Einav, Amy Finkelstein, and Ray Fisman—
About a year ago, Frontier Airlines rolled out its GoWild! All-You-Can-FlyTM pass, offering the possibility of a year of unlimited air travel for the low price of $799. By February, the price tag was up to $1299; by April, it was $1999. Inflation notwithstanding, a price hike of 150 percent in under a year is, well, unusual. Frontier, it seems, is in the process of repeating a classic blunder that has been committed by many businesses over the years, including airlines in the not-so-distant past. About 40 years ago, American Airlines released its own version of GoWild!, with an AAirpass guaranteeing unlimited first-class travel for life. Perhaps hinting at what Frontier has in store, American went through round after round of massive price hikes but still couldn’t make the economics work—every price increase attracted ever-more-expensive customers (like the infamous AAirpass holder who took 16 roundtrip Chicago-London trips in less than a month). These expensive customers drove up costs, which required yet more price hikes. Eventually American threw in the towel and canceled the program. United Airlines also had a similar program—a recent Washington Post story profiled auto consultant Tom Stuker, who bought a lifetime pass in 1990 for $290,000; last year he took flights worth $2.44 million.
While you may not care if American’s shareholders got taken to the cleaners or Frontier CEO Barry Biffle gets canned, the failures of their all-you-can-fly offerings provide an object lesson in the economic force that destroys businesses: the problem of selection. The reason you can’t buy insurance against the high cost of divorce for love or money is selection. Can’t get insurance to help pay the bills if you lose your job? It’s because of selection. Ever wondered why dental insurance is so crummy, why pet insurance is so expensive, why your auto insurer wants to know your credit rating, and why your employer will only let you change your health insurance in the fall? The answer, again, is selection.
Selection afflicts any market in which a business’ costs depend not just on how much they sell but on who they sell to. General Mills doesn’t care who buys their Cheerios. Exxon-Mobile doesn’t care who buys their oil. But Anthem and Humana care a great deal who buys their health insurance policies, because accident-prone couch potatoes can be a lot more expensive to insure than almond-munching gym devotees. Sure, Anthem can take a family history and require a physical exam. But it turns out there’s only so much they can learn about who likes almonds and who prefers cupcakes. Health insurance is a classic case of a market in which its most-expensive-to-serve customers who are most eager to buy the product.
And as Frontier is likely in the process of discovering, when a business responds to having costlier-than-expected customers with the seemingly sensible solution of raising its price to cover its higher-than-expected costs, the remaining customers it attracts are even more costly to deal with. Selection can drive up prices to seemingly ridiculous levels and—as American Airlines learned several decades ago—can destroy a market completely.
Take SafetyNet, a now-defunct provider of layoff insurance, which offered a policy that paid out as much as $9,000 to help its customers survive financially while they looked for work. The problem, we suspect, is that the customers who bought it were the ones about to get laid off. Or Wedlock, a divorce insurance product released in 2010, had a similarly short and unsuccessful run. In hindsight it’s obvious—the couples who are most apt to consider divorce coverage before they tie the knot are probably bickering already on their wedding night. Pet insurance has managed to survive, but the reason it is so expensive – it can set you back more than $4,300 a year for a pet insurance policy on a 12-year-old bulldog which pays out a maximum of just $5,000—is in part because insurers anticipate that most of their customers are the “save Rover at any cost” kind of dog owners rather than the “Rover had a happy life” type.
When markets plagued by selection manage to survive, it’s most certainly not a case of what does not kill me makes me stronger. Most dental insurance won’t cover the four-figure cost of an implant, or other life-improving but expensive dental work. These exclusions make dental coverage less useful as insurance, which exists precisely to provide the peace of mind that if you, say, trip on the side walk and knock out a tooth, an insurer will help to pay for any needed treatment. The problem, though, is that it’s too easy for many dental procedures to be delayed—you can get by without the implant for at least a while—so many customers will wait until after they find out they need expensive treatment before signing up for coverage. To survive, the dental insurance market needs exclusions.
Waiting periods serve a similar purpose. You can’t change your roadside assistance plan whenever you want because AAA doesn’t want you calling to sign up for the platinum plan from the side of the road. (Both layoff and divorce insurance tried some of these tricks. SafetyNet policyholders had to wait six months before getting any payout; the waiting period for Wedlock divorce insurance was four years. But it wasn’t enough to save them.)
These failures are very much to society’s detriment. We’d have better protection against financial calamity if dental insurance didn’t come with pages of exceptions and exclusions. Workers would benefit from the peace-of-mind provided by layoff insurance. Newlyweds might want to insure against the cost of hiring a divorce lawyer if marital bliss proves fleeting.
Perhaps ingenious entrepreneurs will devise profitable ways of selling divorce or layoff insurance. Maybe Frontier management will still figure out how to tweak GoWild! to make their version of an all-you-can-fly program work (there are some devious aspects to the options currently available on their website—like a monthly version that auto-renews for $149, which may be great for fleecing inattentive customers or those who can’t figure out how to find the “cancel auto-renewal” page). But if they do, we’d guess that some of the tricks they use will end up making their coverage a lot less useful than it would otherwise be, were it not for selection.
Liran Einav is a professor of economics at Stanford. Amy Finkelstein is a professor of economics at MIT. Ray Fisman is a professor of economics at Boston University. This essay is adapted from their recent book Risky Business: Why Insurance Markets Fail and What To Do About It.