• July 25, 2014

A Novel Idea to Keep Students in College: Failure Insurance

Imagine a first-generation college student whose high-school preparation was less than ideal. She has just finished her first semester, and she realizes now that college is going to be tougher than she had hoped. She failed one course and struggled to earn C's in her other subjects. She worries that she'll eventually flunk out, and she wonders whether she should walk away now before she accumulates any more student debt.

But what if she could hedge her risks by buying a "failure insurance" policy that would reimburse her for a portion of her student-loan debts if she did flunk out? Would that make her more willing to stay for another semester?

Failure insurance might sound outlandish—but a well-designed insurance system could actually improve students' effort and their attainment rates, according to a working paper that was presented in Atlanta last week at the annual meeting of the American Economic Association.

The paper's authors—Satyajit Chatterjee, an economist at the Federal Reserve Bank of Philadelphia, and A. Felicia Ionescu, an assistant professor of economics at Colgate University—do not have a blueprint in their pockets for such an insurance program. What they put forward in their paper is something more abstract: a set of formal models that prove, in their view, that failure insurance might work.

The authors begin by presenting mathematical models of students' decisions to enroll in college and to put effort into their schoolwork. In the authors' view, those decisions are shaped by students' finances, their beliefs about their future earnings, and by the amount of misery—"disutility," in econospeak—that they suffer when they do academic work.

The paper, "Insuring College Failure Risk," concludes that it is theoretically possible to create failure-insurance policies that would hit a sweet spot. That is, the insurance policies' potential payoffs would not be so high that they would give students an incentive to shirk on their schoolwork, but would be high enough to make students more comfortable with staying in college and taking on more debt. Staying in college would allow some of them to develop better study skills and to put themselves on a path to graduation.

The authors speculate that the insurance might be offered as a component of the federal student-loan program, but they do not describe a concrete policy apparatus. The purpose of the paper is simply to argue that insurance can work in theory.

At this point it's impossible to say whether this working paper will be anything other than a blip in the scholarly literature. Many scholars, of course, emphasize the idea of easing students' debt anxieties in a more obvious way, by lowering tuition and increasing grant aid. And others have recently been exploring financial incentives for students to take full course loads and to earn high grades.

But regardless of whether it is ever put into practice, Mr. Chatterjee and Ms. Ionescu's provocation has already drawn attention from The Wall Street Journal, The New Republic, and the Student Lending Analytics Blog.

Mr. Chatterjee and Ms. Ionescu answered questions from The Chronicle by e-mail last week. (They composed their answers together.)

Q. What does your mathematical model suggest about why too few people attempt college and why too few people complete it?

A. In our numerical model, some students are discouraged by the financial risk associated with a student loan—namely, the student realizes that she may take out a loan but fail to earn a degree. This risk discourages some students from attempting college. Among students who do attempt college, some drop out after learning the effort required to earn a degree. The decision to drop out is also affected by the perception of financial risk. The greater the risk, the more likely it is that a student will drop out.

Q. As a practical matter, what would an optimal insurance system look like? How would the system minimize the incentives for shirking?

A. Practically speaking, we would expect our insurance scheme to work as follows: A student will be eligible for loan forgiveness if he or she has "failing" grades. Currently, a student must maintain a certain GPA in order to be eligible for a student loan. The same standards can be applied to determine whether a student has "failed" and is therefore eligible to collect insurance. In the event of failure (so defined), the student is forgiven a portion of his or her outstanding student loan. Since only a portion of the loan is forgiven, the student still bears some financial risk. This residual risk is like a deductible in a standard insurance contract and will lower the incentive to shirk.

Q. Are you hopeful that real-world institutions could actually produce the optimal insurance system that you modeled in this paper?

A. We don't have a good sense of this. However, here is a thought. In principle, our insurance scheme could be implemented by a school rather than the federal student-loan program itself. Since schools are in a better position to monitor effort, and therefore minimize the shirking problem, it is conceivable that our scheme might appear attractive to schools that are suffering from too many dropouts or failures.

Q. Why could an insurance system be superior to the kind of income-contingent repayment schemes that Milton Friedman favored?

A. It is superior in the sense that our scheme is not likely to be affected by moral hazard. The reason is that the gain from obtaining a college degree is pretty large in expectation, and most students will not want to stop working hard in college simply to get a portion of their student loan reimbursed when they fail. (This may not be true if the likelihood of failure is very high; for this reason our proposal may not be applicable to students with very low preparation for college—in our quantitative work, we exclude students with SAT's below 700.)

In contrast, we believe Friedman's proposal ties repayment to earnings. His scheme would lower repayment when income is low, which gives an incentive to cut back on effort (just to lower payment on the student loan).

Q. In your paper, you model students' study effort as a binary variable—that is, you assume that students are either working full-tilt or they're completely shirking their studies. But does that really make sense? Many students are highly motivated to finish college but are also juggling jobs and family responsibilities. Those students often take conscious or half-conscious risks with their schoolwork—trying to calculate the minimum amount of effort that will earn them a B or C. Could an insurance system move these students along a continuum of effort?

A. We do believe that it is sensible to model effort as a binary variable. We think that if a student finds it optimal to exert any effort in college at all, he or she will find it optimal to exert as much effort in college as possible. The reason, again, is the large college premium in earnings. However, it would be important to explicitly model continuous effort and make sure our intuition on this is correct. We plan to investigate this point in future revisions of the paper.

Your point relates also to something we ignore—which is how a student allocates effort across courses. Potentially, offering insurance against failure could alter the amount of effort allocated to a particular class and may even affect how many and what kind of courses a student takes. These issues would also be important to look into in future work.

Q. In your paper, you assume "that once students fail, they never attempt college again. … Once a student avails herself of insurance, she cannot re-enroll in college without repaying the indemnity with interest." Could you elaborate on that? Wouldn't that rule create a serious barrier for those students who move from institution to institution over a long period of years before they graduate?

A. Upon reflection, we think that an alternative arrangement would be better. Instead of requiring a student to pay back the indemnity with interest if she re-enrolls in college again, the insurance program could stipulate that once a student avails herself of insurance, she cannot get insurance again. She is, of course, free to go to another college but she will not be eligible for insurance against failure.

Comments

1. mbelvadi - January 11, 2010 at 07:10 am

"We think that if a student finds it optimal to exert any effort in college at all, he or she will find it optimal to exert as much effort in college as possible." I think these researchers need to spend a few hours reading the Chronicle Forum discussions that document all those horrific "but I need to pass this class!" conversations that profs have with students when grades are handed out. Researchers who assume rational decision-making by students when it comes to effort to pass classes maybe don't teach a lot of undergrads (or have their TAs deal with them)?

2. handley - January 11, 2010 at 07:45 am

In my opinion this will have the opposite effect from what is intended. Students will feel less pressure to stay in school if there are limited financial consequences for dropping out.

3. jwcarroll - January 11, 2010 at 08:49 am

"We think that if a student finds it optimal to exert any effort in college at all, he or she will find it optimal to exert as much effort in college as possible." If this were the case, they wouldn't need failure insurance because they wouldn't be failing. Students already make rational choices about how much effort to expend toward achieving a particular grade and staying in school. Lowering the cost of dropping-out will lead to more drop-outs. Modeling insurance against student failure for the lender might yield an entirely different picture of student failure risk.

4. hms3683 - January 11, 2010 at 09:11 am

The proposal at hand is another example of the abuse of insurance that has led America into the 2nd great depression. We should keep in mind that all insurance, from the point of view of a consumer, is a bet against oneself. In this case, it's only a little more obvious than usual that this is what is going on. How many students are entering college thinking "I'm too stupid to be here, so I'd better bet that I'm going to fail so that I can fail and collect on my policies?

5. cjones599 - January 11, 2010 at 10:11 am

I am glad to see bright economists look at this idea. When I first read about this idea, I thought it was worded in such a way that students would feel like failures before they even begin.
I agree with post 4. Is there a way to structure the concept so that it would be read in the positive? Is there a way that students can "bet" they would actually finish college, and the reward would be the proceeds of an insurance policy to cover all or most of the student loans? I don't have a model, but if you or others could create one, I think that would be a better idea.

Also I feel that the underprepared students need equal access to the benefits of an insurance policy. What are some ways to make that happen?

6. mvclibrary - January 11, 2010 at 10:25 am

And what of the incentive for lower tier schools to enroll even more marginally (or not at all) prepared students? How will this insurance impact student loan default calculations?

7. johntoradze - January 11, 2010 at 11:25 am

"And what of the incentive for lower tier schools to enroll even more marginally (or not at all) prepared students? How will this insurance impact student loan default calculations?"
- Look no further than University of Phoenix, with its 4% graduation rate.

8. johnburningham - January 11, 2010 at 11:25 am

How about insteat of rewarding failure, part of the student's loan is forgiven for academic success!

9. intered - January 11, 2010 at 11:41 am

A few other thoughts:

(a) We have yet to appreciate the power of constructive problem-solving relationships with a retention counselor:

http://www.intered.com/higheredbriefing/2009/12/8/increasing-retention-via-incremental-changes-part-i.html

(b) Three year degrees will help as well:

http://www.intered.com/higheredbriefing/2010/1/5/the-three-year-degree-part-ii.html

(c) Positive incentives of tuition rebates (as mentioned in the above post) can be balanced with the negative incentive of eliminating tuition assistance (student loans, scholarships, etc.) when matriculation exceeds the established time-to-degree.

Our work suggests that at least half of failures to graduate could be eliminated if the institution would create service systems based on the view that each student is a valuable resource to be served, rather than ignored and even abused, by the system.

Robert W Tucker
President
InterEd, Inc.
www.InterEd.com

10. johntoradze - January 11, 2010 at 12:03 pm

This idea truly is worthy of a Saturday Night Live skit, not a serious proposal! I can only presume it is someone's ridiculous PhD thesis, or worse, some post-doctoral attempt at infamy in pursuit of a professorship that should be laughed out of the room. Just because it described by some rubbishy math doesn't make it any more serious than scribbling "The door equals (Pi/e)/sqrt(my foot)."

Dear god. Rarely have I seen such a display of basic lack of comprehension of business models. First, such insurance would never work unless all students were required to participate, and they make no such mandatory provision. Otherwise, no insurer would take on a student who wanted to buy such insurance. An insurer would have to be insane to sell such a policy for a price that was affordable to the few students who wanted them. Without ability to price insurance within range of affordability the proposal is dead on arrival. I will note that the laughable grasp of pricing theory for insurance displayed by these two was apparently used by AIG to price credit default swaps. (Not a joke.)

Second, if everyone were required to participate, then there would be an incentive to drop out or fail out. Student loans pay for more than just tuition. Thus, the optimum strategy would be to bail out a few credits short of graduation in order to pay the loans off.

Third, what is dropping out or failing out of college? Are they the same? If not, is it actually better for society to pay off the loans of those who fail and not pay off those who must leave for other reasons like financial stress? In any case, when there is a financial incentive to fulfill whatever the requirements are to get one's loans paid off, does anyone think undergrads won't figure out a way to have their cake and eat it too? Now, with no incentives, it's easy to tell. You just ask, they say. But with financial incentives that could rise to 3 times the likely yearly income of a dropout? Give me a break. Without a clear definition that can't be gamed (by either side of the transaction) this proposal is again, dead on arrival.

Fourth, there would have to be a way to re-enter. If there were no time limit on being required to repay the insurance collected (with interest) there would be a near absolute disincentive to ever re-enter college again. If there were a time limit, then a student could simply transfer credits somewhere else, restart (perhaps overseas) and finish in one quarter having vanquished their debt.

Fifth, how can schools possibly offer such insurance? Can anyone say, "Conflict of interest?" Does anyone involved in university administration in these cash-strapped times actually think that professors would not be pressured to prevent students from fulfilling the requirements for payoff of the policy? Does anyone think that as times became harder for students that they would not feel pressured to force the school to pay them off?

Sixth, who on earth thinks students would be willing to pay a cent to such a program? Students recently attacked the home of the Chancellor of UC Berkeley with rocks and torches to set it afire over tuition increases.

I could go on, but I'll stop there. The fact that this proposal has even seen the light of day, and gotten past someone who claims to be a professor of economics should be an air raid siren to all of us. This is an economist's perpetual motion machine design. It is ludicrous in the extreme, a castle in the sky built on nothing at all. The reason it should alarm us all is that there is concomitant evidence that such idiocy has taken over our financial sector. Look no further than the bailout of AIG and the financial gaming of Citibank, Bank of America, Lehman Bros, et al.

Dear god. These two should be thrown out on their ears for promulgating such rubbish, along with anyone else involved with them. Anybody can throw a rubbish model together and get any result they like.

11. davi2665 - January 11, 2010 at 12:30 pm

Yet another absurd bailout proposal that would require printing more money and borrowing far beyond the payments put in to provide questionable benefits that would only encourage poor performance. It makes almost as much sense as a bailout proposal to insure that small businesses that fail get paid back for the investments. Only when someone has a serious investment in resources and time does the incentive arise for working to maximal capacity. This proposal is yet more of "I want someone else to take care of me".

12. owliebehn - January 11, 2010 at 01:18 pm

How many students enroll to get the financial aid monies to "tide them over." Earning a college degree is not the real intent in the first place.

13. lynnbhardin - January 11, 2010 at 01:56 pm

In order to help those students "whose high school preparation was less than ideal", they should be encouraged to ween themselves into the college curriculum by taking lighter academic loads. By concentrating their efforts on fewer subjects they can increase their chances on success in each subject. However, some forms of financial assistance penalize students when they do not take a "traditional" full-load. Redefining our what we consider a full-load might alleviate the need for failure insurance.

14. hallcarol - January 11, 2010 at 06:33 pm

What a bad idea - there have to be ramifications for actions or there will be no avoidance! Not to mention that all our required insurance policies now are nothing but a way of making the populace shovel money into a bottomless pit called an insurance company. Give them an "A" for creativity and filling a niche give them a "D" for ethics and responsibility.

15. jwcarroll - January 11, 2010 at 10:32 pm

Regarding comment #7, what is the basis for your claim the graduation rate at UoP is 4%?

16. panacea - January 11, 2010 at 11:15 pm

davi2665 said, "Yet another absurd bailout proposal that would require printing more money and borrowing far beyond the payments put in to provide questionable benefits that would only encourage poor performance."

I disagree. I see just the opposite occuring. Any insurance company who would offer such a policy would have to word it very carefully to make a profit. No insurer would reward failure with a payout. The idea of insurance to them would be to collect premiums and minimize payouts, just as in health insurance today.

This would result in policies pitched to families that don't need them, defeating the stated purpose, or in the creation of yet another bureaucratic labrynith for policy holders to navigate.

Auto and home insurance has provisions to encourage responsible behaviors to avoid disasters (car accidents, home fires, burglaries). Hence, discounts for good grades, alarm systems, airbags. The student would have to be able to demonstrate behaviors that reduce risk. Students whose academic performance is marginal to begin with would not be eligible, and those whose academic performance is stellar do not need it.

The one issue that has not been discussed, that is often a barrier to academic success, is life issues that derail a previously successful student. For example, a death in the family causing the loss of tuition support, a personal illness that forces the student to drop out of school. Insurance for good students tuition wise who face challenges they could not control might prove a viable business model.

But the system as discussed is not workable.

17. johntoradze - January 12, 2010 at 10:01 pm

The 4% graduation rate from UOP is here:
http://oedb.org/rankings/graduation-rate
Online College Ranking by Graduation Rate

University of Phoenix' graduation rate is that low. Now, perhaps it is plausible that the rate increases at 8 years for a 4 year degree, but a rate of 4% is just astonishing.

What I take away from it and from what I know of a couple of UOP graduates is that the degrees themselves are sound - if you can get one. The problem is the school appears to be terrible for most students.

18. johntoradze - January 12, 2010 at 10:03 pm

Seriously people. I find this proposal from these two "economists" to be so asinine I am even more appalled by it than I am by the UOP graduation rate being so abysmal.

19. johntoradze - January 12, 2010 at 10:06 pm

Ok. I looked back to see who these (ahem) individuals are. While I am appalled that one works for the Federal Reserve, I do not find myself surprised. Just look at what is going on in the finance sector. The wheels came off. These kinds of creatures are why.

The assistant professor of economics? ...

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