Tom Baker & Peter Siegelman

Abstract

Persistently high profits on “insurance” for small-value losses sold as an add-on to other products or services (such as extended warranties sold with consumer electronics, loss damage waivers sold with car rentals, and credit life insurance sold with loans) pose a twofold challenge to the standard economic analysis of insurance. First, expected utility theory teaches that people should not buy insurance for small-value losses. Second, the market should not, in the long run, permit sellers to charge prices that greatly exceed the cost of providing the insurance. Combining the insights of the Gabaix and Laibson shrouded pricing model with the behavioral economics of insurance, this article explains why high profits for add-on insurance persist and describes the negative distributional and welfare consequences of an unregulated market for such insurance. The article explores four potential regulatory responses: enhanced disclosure, a ban on point-of-sale offerings of add-on insurance, price regulation, and the creation of a new online market. Drawing on theoretical, empirical, and comparative law sources, the article explains why enhanced disclosure will not work, identifies the circumstances in which a point-of-sale ban is desirable, and argues that a new online market is preferable to price regulation when a point-of-sale ban is undesirable.

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