(SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU'S "LOST SITUATION")
ROBERT SMITH, HOST:
Hello, and welcome to PLANET MONEY Summer School, the only economics course that you never want to end. And yet here we are, the last class, No. 8 - "Risk & Disaster." I'm Robert Smith. And I should say that just because it's the last class does not mean that you are done. With all of your newfound economic knowledge, you need to take the final exam, which we have now posted at npr.org/pmsummerschool. Don't worry; I'll remind you again at the end of the episode. And next week, some of you, our listeners, will speak at our audio graduation. You do not want to miss this episode. It will be inspirational.
Back with us today on our final journey are our resident economists, Justin Wolfers and Betsey Stevenson. Hey guys.
BETSEY STEVENSON: Hi.
JUSTIN WOLFERS: Hey.
SMITH: Who's the big risk taker in your family, Justin Wolfers or Betsey Stevenson?
WOLFERS: I grew up working for professional gamblers.
WOLFERS: Yeah. Now, you might think that makes me the one who loves risk the most. But in fact, professional gamblers, like people in finance and on Wall Street, are so aware of risk, they're always leery of taking on unnecessary risks.
STEVENSON: Yeah. I think that that is true. It's funny that you bring up the issue of who's the person who takes more risks in our household. You know, being economists, we have actually a pretty common language for being able to talk about risk and to think about trade-offs across risk many times.
WOLFERS: I'll always let the kids swim in the ocean with sharks. I still love them. I just think the probability of them getting eaten is pretty low.
STEVENSON: Right. So risk is simply a set of probabilities, then the payoffs, the outcomes, what's going to happen, associated with those probabilities. So it's not that some things are risky and other things aren't. Risk is on a spectrum. You know, that's why you can have a discussion with someone. If you say, hey, I don't want to do that. It's too risky. What do you mean? Is it that you think the probability of risk is too high for you or how you value the outcome that would happen if the bad thing happened is different from the other person?
SMITH: Yeah. And, of course, avoiding risk also has a cost. If you don't swim in the ocean because you're afraid of sharks, then you miss the joy of being in the cool water on a summer day. By the way, that's known as opportunity cost. You should know that. Or if you're trying to avoid the financial risk of your house burning down, then you're going to have to pay the cost of insurance, which is what our show focuses on today - the strange world of risk and insurance, putting a price on all the bad things that might happen. We're going to play an episode from 2014 hosted by me and Jacob Goldstein. And then we'll return at the end for our final Summer School lesson. I'll let Jacob take it from here.
(SOUNDBITE OF ARCHIVED NPR BROADCAST)
JACOB GOLDSTEIN: My wife and I recently bought a house for the first time. And a few weeks after we moved in, we got this envelope in the mail. Inside the envelope was my homeowners insurance policy. I got it right here. It's a little booklet, 23 pages long, printed on this thin paper. And it says in little letters on the front, please read your policy carefully. So because, frankly, that's the kind of thing I'm into, I did. I read it. The policy blew my mind. I mean, it's a totally standard policy. Millions of other people have this exact same booklet. But the contents, the details, are amazing. It's like somebody took all of the bad things that could happen in the world and divided them into two buckets - stuff that is covered and stuff that is not covered.
For example, I'm covered for damage caused by riot or civil commotion. All right. I'm covered if a missile hits my house. I'll take it. But I am not covered if a missile hits my house in a war. Also, if that missile happens to be a nuclear missile, I'm not covered whether there's a war on or not. I live in Brooklyn, where, as far as I know, there are no volcanoes, but there is a volcano section of my policy. If a volcano shakes the ground and damages my building, I'm out of luck. But if a volcano spews lava onto my house, I'm covered - says it right here - additional coverages, Paragraph 10, volcanic action.
SMITH: Today on PLANET MONEY Summer School - strap in, everyone - we're going to read Jacob's insurance policy from the beginning to the end and show the economics behind all that fine print.
(SOUNDBITE OF ARCHIVED NPR BROADCAST)
SMITH: OK, from the top - (reading) State Farm Insurance Condominium Unit Owners Policy FP-7956.
GOLDSTEIN: That's my policy, FP-7956. And to understand what it means, where all this stuff comes from, I needed to find a law professor, somebody who is really, really, really into insurance. As it happens, law professors like that - not that easy to find.
DANIEL SCHWARCZ: Law professors are obsessed with things like constitutional law and, you know, ethics and broad, sexy types of questions.
GOLDSTEIN: So, wait; are you telling me that insurance is not sexy?
SCHWARCZ: Well, it's sexy in the right light.
SCHWARCZ: But you might need a little bit of airbrushing, you know.
GOLDSTEIN: This is Daniel Schwarcz. He is, yes, an insurance expert and a law professor at the University of Minnesota. And to start out with, we talked about a simple one, the first thing my policy covers.
SMITH: Section 1 - losses insured. Paragraph 1 - fire or lightning.
GOLDSTEIN: That's it. There's no asterisks, no buts. If my house burns down, I'm covered.
SMITH: This paragraph, Schwarcz says, is interesting because it is where all homeowners insurance began. Before the 20th century, fire was the one huge overwhelming risk. Houses were made of wood and people cooked with fire. I think we can see the problem there.
GOLDSTEIN: And people in the U.S. were buying fire insurance all the way back in the 1700s, back before even public fire departments existed. So insurance companies basically created their own private fire departments. Schwarcz says when you bought a policy back then, you did not get 23 pages of policy printed in a little booklet. You got this metal sign, this shield to put up outside your house.
SCHWARCZ: The fire department would come, and if you had the shield that said that you were insured against, they would put out the fire.
GOLDSTEIN: And if you didn't?
SCHWARCZ: And if you didn't, they wouldn't.
GOLDSTEIN: Homeowners insurance as we know it, the 23 pages of fine print...
SMITH: Things like Paragraph 2 - wind, storm or hail, Paragraph 3 - explosion.
GOLDSTEIN: Yeah, these things come in in the middle of the 20th century, around the time of the GI Bill and of people moving to the suburbs and lots and lots of people getting mortgages. The banks behind those mortgages start to say, hey, we are not going to lend you all this money unless you buy solid insurance to protect the house against more than just fire.
SMITH: Things like Paragraph 4 - riot or civil commotion, Paragraph 7 - smoke, Paragraph 8 - vandalism or malicious mischief.
GOLDSTEIN: So all of a sudden, insurance companies have to decide. We've got this whole universe of risks. What is in and what's out? What is covered and what is not covered?
SMITH: And so they created this big, complicated section - losses not insured. And it's this section - all the stuff that insurance does not cover - this section tells you how insurance really works. We asked Schwarcz to help us decode it, and we started with Paragraph 2, subparagraph E - war.
GOLDSTEIN: War. I am not covered for war, including any undeclared war, civil war, insurrection, rebellion, revolution, warlike act by a military force or military personnel. What does that mean? I never even thought about it. But now that I know that I'm not covered for war, like, I'm kind of nervous.
SCHWARCZ: Well, when war occurs, lots and lots of property is destroyed. And when lots and lots of property is destroyed at the same time, it's very hard for insurers to actually cover that.
GOLDSTEIN: So if you're insuring London in 1939 and war is covered, you're essentially about to have to pay to rebuild all of London, which is about to get blown up.
SCHWARCZ: Exactly. And not only that, but you will be unable to pay that and you will go bust, and many people will never get paid in the first place.
GOLDSTEIN: War is what insurers call a correlated risk. If, God forbid, my house gets blown up in a war, it is much more likely that, say, Robert - I'm sorry to say it - your house 10 blocks away from mine would also be blown up. It's much more likely that my sister's house in Florida would also get blown up. Correlated risks like these are really hard to insure against.
SMITH: Yeah, what insurers really want to cover is the opposite - things like fires. Now, if my house burns down, that doesn't make it much more likely that Jacob's sister's house in Florida is going to burn down. And the number of homes damaged by fire really doesn't vary that much from year to year. That makes it easy for insurers to just basically do the math, figure out how many fires there's going to be and how much they're going to charge for fire coverage.
GOLDSTEIN: So when you see that long list of things your insurance company doesn't cover, a lot of that is stuff that just kind of breaks insurance, things that are so big that insurers just can't handle them. If they tried to cover those things, they would go bust. They could never pay all the claims.
SMITH: Things like Paragraph 2, subparagraph F - nuclear hazard, or Paragraph 2, subparagraph C, item 1 - flood, surface water, waves, tidal water, tsunami, overflow of a body of water, spray from any of these, all weather driven by wind or not.
GOLDSTEIN: When things like this happen in the world, there are a lot of people who wish they had read all the fine print in their policy. Jeff Waddle, a State Farm agent in Greenwich Village, says nobody does that.
JEFF WADDLE: In reality, no. In six years, I've maybe had three people - three people who have actually read their policy or at least read part of it and, you know, highlighted parts that they wanted to talk about.
GOLDSTEIN: So that's three people out of about how many?
WADDLE: Well, I have 5,000 customers with homeowner policies. So, I mean, do the math.
GOLDSTEIN: This was a problem after Hurricane Sandy hit. Lower Manhattan was a complete disaster. People had to leave their homes. And they did what you do when you're hit by a disaster. They called their insurance agent. And Jeff had to tell them the bad news.
WADDLE: It was very difficult because down here where we're located, we didn't have power. The majority of my customers live down here. They didn't have power. Unfortunately, we had to explain the reason for the power outage was due to Sandy, which was flooding, and flooding's not covered. So their hotel stay, their expenses associated with not being able to live in their apartment were not covered under the policy.
GOLDSTEIN: OK, so now I understand the big exclusions - the floods, the missile during wartime. But there's this part of the policy that still just seems weird.
SMITH: OK, I've been waiting to read this one. Additional coverages, Paragraph 10 - volcanic action.
GOLDSTEIN: Volcanic action, even in insurance world, is confusing. If you go to - what is it? - Page 6 of my policy...
SMITH: You know this thing so well at this point.
SMITH: Look at that.
GOLDSTEIN: It's well-thumbed. It - OK, Page 6. It says volcanic action - it basically tells me, don't worry about volcanoes. I am covered for lava flow or ash or volcanic blast. So, OK, I'm good, I think. But then, if I flip ahead to Page 10, here under Earth movement, I am not covered for Earth movement, whether it is caused by a volcano or a mudslide or, most importantly, an earthquake.
SMITH: And to be honest, although volcanoes are scary, the earthquake is the real concern here. Earthquakes are generally not covered by insurance companies for two main reasons. One is the thing we've already talked about, the correlation. For instance, after the Northridge earthquake hit LA in 1994, the LA Times reported that insurance claims on that earthquake were more than all of the earthquake premiums ever collected in California.
GOLDSTEIN: But Schwarcz says there is this other big, fundamental thing that makes it hard to cover earthquakes.
SCHWARCZ: Insurers normally, when they sell you a policy, they want to make sure that they have roughly the same amount of information that you have as a policyholder, or even more. Otherwise, there's a possibility that only the really risky folks will purchase insurance.
SMITH: Normally, we try to avoid all the lingo, but this is a show about insurance, so let's just go for it. The fancy term for this is adverse selection. Insurance only works if all sorts of people buy the insurance, right? But who really wants earthquake insurance? People who live on top of a fault line - people in California, basically. Now, who is not willing to pay extra? Everyone else. Jacob lives in Brooklyn. So when this happens, when the only people who buy insurance are the ones most likely to be hit by the problem - when this happens, insurance does not work.
GOLDSTEIN: So when my policy excludes earthquakes caused by a volcano or whatever, what the policy is really saying is if I want earthquake insurance, I'm going to have to pay extra. And for that matter, if I ask for earthquake insurance, the insurance company is going to send someone out to my house and make sure it's not, you know, some pile of rocks built on top of sand sitting over the San Andreas Fault.
SMITH: (Laughter) It is amazing how much of your policy finally makes sense when you know these two terms - correlated risk and adverse selection. But there's one last thing that puts a lot of sort of random stuff into the not-covered bucket.
GOLDSTEIN: What are some of the other sort of big things that are not covered?
WADDLE: Bed bugs. Lots of - you know, a couple years ago especially, when bed bugs was really prevalent in the news, a lot of customers were freaking out.
GOLDSTEIN: It's weird that bed bugs aren't covered because bed bugs, despite what you may have heard on the local news, are not like an earthquake or a flood. They're relatively isolated, and they're not that expensive to deal with compared to some giant disaster.
SMITH: Insurance companies won't pay for bed bugs or any other kind of bugs or vermin for a different reason. They don't want to give you an excuse to be an idiot. I mean, think about it. If I had bed bug insurance, I would furnish my entire apartment from random things I find on the street in Brooklyn. What's the worst that could happen? I have bed bug insurance.
GOLDSTEIN: This excuse-to-be-an-idiot problem, the formal name is moral hazard.
SCHWARCZ: Moral hazard essentially involves being less careful because you have insurance. And so if you have insurance, you have less reason to be careful and you have less reason to take care of losses when they are occurring because the insurer will pay for it. And so there's not much reason for you to take care. And especially if the care itself costs money or is difficult or is not fun, you'll just be less careful.
GOLDSTEIN: My policy is actually full of language trying to deal with moral hazard, trying to make sure I don't become just a slacker and assume insurance will solve all my problems. If there's a leaky pipe and I don't fix it, I'm not covered. If I leave my apartment vacant and it gets vandalized, I'm not covered. Moral hazard even explains one of the most mysterious details in my policy.
SMITH: Losses insured, Paragraph 10 - falling objects.
GOLDSTEIN: I am covered for damage from falling objects - a tree or a satellite or whatever - but only if the falling object first damages the roof or an exterior wall of my building. And I read this, and I kept thinking, what other damage could I have from a falling object? Schwarcz explained.
SCHWARCZ: This coverage excludes scenarios in which there's some falling object in your home - right? - that's not caused by an external force...
GOLDSTEIN: Oh, right (laughter).
SCHWARCZ: ...That's caused - right. So, you know, let's say that your television - you know, you put up your favorite bowling ball right, you know, on your shelf, and the bowling ball falls and smashes into your television. Well, that's not going to be covered because, probably, you should've been more careful about where you put your favorite bowling ball.
SMITH: I know it seems far-fetched, but the people who write insurance policies are constantly dreaming up new scenarios that may or may not be covered by the policy. We talked to people in the industry, and they say that they watch the news, hunting for new lawsuits or new court cases that give them a peek into the kind of accidents and claims that might be out there just around the corner. And they start drafting new language in their policies just in case.
It isn't hard to imagine that right now, in 2020, there are pages being added to insurance policies all across the nation including what was previously unthinkable - speculative subparagraph W, policy does not cover costs associated with pandemics, viruses - corona or otherwise - mask-related injuries or damage, home-schooling accidents and video conferencing mishaps including but not limited to Zoom, GoToMeeting, Microsoft Teams, et cetera, et cetera, et cetera.
After the break, our economists will have some home study tips for the final exam.
So now that we've considered the fine print of an insurance policy, let's take this bigger. Let's talk about how economists think about insurance and all the things we discussed in the episode. With us are our dynamic duo of economists, Justin Wolfers and Betsey Stevenson from the University of Michigan. Hey.
SMITH: So one thing we didn't get into in this episode because we were really dealing with Jacob's policy alone, why do we buy insurance in the first place? Like, why are there so many things that we insure, and how do we decide what we insure and what we don't?
WOLFERS: We buy insurance because we don't like risk. Think of a risk as being, heads - life gets better, tails - life gets worse. The problem is that when bad outcomes occur, we become really miserable. When good outcomes occur, we become only somewhat happier. So the downside in terms of what it does to your quality of life is much worse than the upside. So you'd rather not have that risk in your life, so you can buy insurance.
So, heads, you've crashed the car, but then the insurance company pays for a new car. Or actually, in terms of this episode, heads, something bad happens to your house, but then the insurance company pays for your repairs so you no longer have those unnecessary financial fluctuations in your life.
STEVENSON: That means if, like, the bad outcome doesn't happen, you know, you put money into the pool that helps somebody else when it does. And so, you know, insurance has just been part of a community where we all chip in to a big pot of money. And when somebody's house burns down, they get the pot. That's what insurance is. And people like that because they would rather pay a certain amount up for sure than take a gamble that they have a huge loss that could maybe wipe them out or really change their quality of life.
SMITH: Another fascinating concept in the episode is moral hazard, probably my favorite economic name there is - moral hazard. And moral hazard is basically once the risk has been taken off my shoulders by an insurance company or by a pool of people who are willing to take risk off my hands, then I have every incentive to just lead a riskier life.
STEVENSON: So I just have to say I hate this phrase...
SMITH: Do you? I love it.
STEVENSON: ...Because it has...
STEVENSON: It has this judgment towards it. Like, when individual people optimize for themselves, well, hey, that sounds a little immoral. When have you ever referred to a company profit-maximizing as engaging in moral hazard, right? All that these people are doing is they're saying, hey, I don't bear the benefit of taking these costly actions anymore. When you face costs but no benefits, you know, any kind of person who's trying their best to get the most out of life, they don't take costly actions that have no benefits to them.
STEVENSON: Let me just say no benefits to them. The problem is the benefits are going to the insurance company, and that's one of the reasons why the insurance company's paying you to go to the gym, by the way. They're like, hey, if you stay healthy, your medical bills will be lower, so get off the couch. Go to the gym. They want to give you that incentive.
SMITH: I do remember the one time that I bought the full and complete optional insurance on my rental car was the time I was going to drive into the desert into one of the most dangerous ravines there was in the country. And I'm like, you know what? I'm going to buy the full insurance at this point.
WOLFERS: You - that sounds like adverse selection, right?
STEVENSON: Yeah, that's adverse selection. That's like, you know, the insurance company - you know who they didn't want to buy that policy? You. Do you know why that rental insurance policy's so expensive? 'Cause the only people who buy it are you.
SMITH: I did. When I walked in, I did not wear my hiking boots and bring my backpack because I'm like, oh, they'll spot me.
WOLFERS: The general idea of adverse selection really is you won't get the customers you want. That's an idea, by the way, that goes well beyond insurance. If you were to open an all-you-can-eat buffet in a college town, who's going to turn up? It's going to be the football team.
SMITH: I do sometimes mix up adverse selection and moral hazard.
STEVENSON: I do think there's an easy way to actually just keep the two straight. Adverse selection we think of as the types of people or the types of customers you're getting. So who you were at the time was leading you to buy insurance. If - on the other hand, when we think about moral hazard, we're talking about actions, and you're not getting the actions from your customers that you want. If you rented a car and you bought all the insurance and then you said, oh, let's go off-riding; it doesn't matter; I'm fully insured, those are the actions you're getting that you don't want from your customers.
WOLFERS: So it's a hidden type or a hidden action.
SMITH: Is there a way for a company to get rid of this moral hazard?
WOLFERS: Push people to have skin in the game. A car rental company that makes you pay the first thousand dollars or the first $2,000 of any damage you do to the car - all of a sudden, it's not free for you to speed. It's going to be somewhat costly, and it's going to lead you to take a little bit more precautions.
STEVENSON: The bottom line is that when we think about insurance, the insurance company really wants to protect you against events and outcomes that you have no control over. But there are very few things where we have absolutely no control over them. Most things in life are some mixture of our actions and luck. And the insurance company wants to insure you on the luck side but, unfortunately, often gets stuck dealing with your actions as well.
SMITH: Betsey and Justin, this is our last class.
SMITH: And there's one more thing that I want everyone to do. It's a final exam. It's short. I cannot promise it's easy, but it is short. And if you pass this test, then you have truly earned the PLANET MONEY fake diploma.
STEVENSON: That's very exciting.
WOLFERS: You're about to tell me that Betsey and I have to do the grading for all of our listeners.
SMITH: I was going to tell you to save room on your substantial wall of accreditation and diplomas.
WOLFERS: This might be the only one I actually put on the wall, so.
SMITH: What is your advice for people to study for this?
WOLFERS: Look; I'm a textbook author, so I might say buy a textbook.
SMITH: I bet you would.
WOLFERS: But the world is the best textbook, which is - your goal as an economics student is not to learn the economic theorems. It's to learn how to apply them. And as you walk through the world with your eyes wide open, with this Summer School behind you, you're going to see economic forces at play everywhere. And that's when you're learning the most important skill.
STEVENSON: So as you prepare for the exam, I say open the newspaper. Look at the world around you, and use these concepts you've learned and say, how can I think about the world I'm seeing a little bit differently because of what I've learned? And if you can use it, then I know you'll pass it.
SMITH: Thank you both so much. It's been great doing this with you.
WOLFERS: It's been a pleasure.
STEVENSON: It's been a pleasure.
(SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU'S "LOST SITUATION")
SMITH: All right, students. This is it. Go take the final exam. It is at npr.org/pmsummerschool - one word. That's npr.org/pmsummerschool. Good luck, everyone.
And just in case you needed to study, let's go over the big vocabulary words one more time. Adverse selection is about attracting the wrong kind of customers. Imagining opening an all-you-can-eat buffet, and then the football team arrives - adverse selection. And moral hazard is about encouraging the wrong kind of behavior. After you get rental car insurance, you may be tempted to go off road. I'm not saying I did, but you might be tempted because you no longer bear the financial risk. And also, correlated risk- it's a very 2020 word. It's when bad things happen to everyone at the same time, and it's very, very hard to insure against.
Send us your morally hazardous stories with email@example.com. You can also find us on social media - Facebook, Instagram, Twitter and TikTok, which helps fund the wild videos on our channel. We're @PlanetMoney. If you'd like to continue your Summer School learning, may I suggest Justin and Betsey's new audio course/podcast? It's called Think Like an Economist. It's on the Himalaya app and wherever you find your podcasts.
Today's class and the entire series was produced by Lauren Hodges, with help from the entire team - Alexi Horowitz-Ghazi, Darian Woods, Nick Fountain, Liza Yeager and James Sneed. Sound design from Isaac Rodrigues (ph). It was edited by Alex Goldmark. And we'll all be back next week for a very special graduation episode. You all grew up so quick. I'm Robert Smith. This is NPR. Thanks for listening.
NPR transcripts are created on a rush deadline by Verb8tm, Inc., an NPR contractor, and produced using a proprietary transcription process developed with NPR. This text may not be in its final form and may be updated or revised in the future. Accuracy and availability may vary. The authoritative record of NPR’s programming is the audio record.