Finance and Economics Discussion SeriesFederal Reserve Board.Washington.D.C.ISSN 1936-2854 (Print)ISSN 2767-3898 (Online)Navigating Higher Education Insurance:An Experimental Studyon Demand and Adverse SelectionSidhya Balakrishnan,Eric Bettinger,Michael S.Kofoed,Dubravka Ritter,Douglas A.Webber,Ege Aksu,and Jonathan S.Hartley2024-024Please cite this paper as:Balakrishnan,Sidhya,Eric Bettinger,Michael S.Kofoed,Dubravka Ritter,Douglas A.Web-ber,Ege Aksu,and Jonathan S.Hartley (2024)."Navigating Higher Education Insurance:An Experimental Study on Demand and Adverse Selection,"Finance and Economics Dis-cussion Series 2024-024.Washington:Board of Governors of the Federal Reserve System,https://doi.org/10.17016/FEDS.2024.024.NOTE:Staff working papers in the Finance and Economics Discussion Series (FEDS)are preliminarymaterials circulated to stimulate discussion and critical comment.The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors.References in publications to the Finance and Economics Discussion Series (other thanacknowledgement)should be cleared with the author(s)to protect the tentative character of these papers.Navigating Higher Education Insurance:An ExperimentalStudy on Demand and Adverse Selection*Sidhya Balakrishnan',Eric Bettinger,Michael S.Kofoeds,Dubravka RitterDouglas A.Webber!Ege Aksu;and Jonathan S.HartleyFebruary 21,2024AbstractWe conduct a survey-based experiment with 2,776 students at a non-profit university to analyze in-come insurance demand in education financing.We offered students a hypothetical choice:either afederal loan with income-driven repayment or an income-share agreement (ISA),with randomized fram-ing of downside protections.Emphasizing income insurance increased ISA uptake by 43%.We observethat students are responsive to changes in contract terms and possible student loan cancellation,which isevidence of preference adjustment or adverse selection.Our results indicate that framing specific termscan increase demand for higher education insurance to potentially address risk for students with varyingoutcomes.*The authors appreciate the helpful comments and feedback of Neil Bhutta,Julia Cheney,Barry Cynamon,Andrew Hertzberg.Jerome Hodges,Caroline Hoxby,Rajeev Darolia,Robert Hunt,Jeff Larrimore,Joseph Marchand,Lois Miller,Kevin Mumford.Marshall Steinbaum,and Joshua Price.We are also grateful for participants at seminar and conference presentations including theAmerican Economic Association,Appalachian State University,Association for Education Finance and Policy,Association for PolicyAnalysis and Management,Brigham Young University,National Bureau of Economic Research(Economics of Education).ProvidenceCollege,Southern Economic Association,United States Air Force Academy,and University of Tennessee,Knoxville.+Eric Bettinger is the Conley DeAngelis Family Professor of Education at Stanford University and a research associate at NBER.email:ebettinger@stanford.edu.Michael S.Kofoed is an assistant professor ofeconomics at the University of Tennessee,Knoxville and Research Fellow at IZA.Dubravka Ritter is a senior advisor and research fellow at the Consumer Finance Institute.Federal Reserve Bank of Philadelphia.discussion purposes.The views expressedin these papersare solely those of the authors and do not necessarily eflect the views of theFederal Reserve Bank of Philadelphia or the Federal Reserve System.Any errors or omissions are the responsibility of the authors.No statements here should be treated as legal advice.Douglas A.Webber is a senior economist at the Board of Governors of the Federal Reserve,email:douglas.a.webber@frb.gov.The analysis and conclusions in this paper are those of the author and should not be interpreted as refecting the views of the Board ofGovernors or the Federal Reserve System."Ege Aksu is a PhD candidate at CUNY Graduate Center and fellow at the Jain Family Institute,email:Jonathan S.Hartley is a PhD candidate at Stanford University,email:hartleyj@stanford.edu1 IntroductionInsurance products are important tools employed by individuals to hedge risks in their financial lives.Insur-ance markets allow individuals to pool risk against unexpected,negative outcomes and are well developed inmany contexts,like healthcare or real estate.However,risk-hedging opportunities are not readily availablein post-secondary education,even though college is an increasingly uncertain investment (Webber,2022)made only once in a lifetime.While returns to college are positive on average (Lovenheim and Smith,2022),their distribution is more nuanced (Webber,2016,Broady and Hershbein,2020).Financial out-comes for students,for example,vary across institution types (e.g.selective vs.non-selective;four-year vs.two-year),fields of study (e.g.education vs.engineering vs.economics),and macroeconomic conditionsupon graduation (Rothstein,2023).Perhaps more importantly,retums vary within each of these segmentsgiven unobservable student skill-which is potentially difficult for the student and/or the institution to iden-tify-and uncertain labor market conditions.Particularly for younger students and those entering longerdegree programs,there is uncertainty both in the expected level of income and in its variability.Students,educational institutions,and govemment entities understand and bear these risks to differentdegrees.For example,work by Stange (2012)shows that many students treat attending their first year ofcollege akin to purchasing an options contract-completing an initial year so as to develop a better sense oftheir likely returns,after which they decide whether to exercise the option for a second year.Policymakersand advocates often work to transfer the riskiness of the return to taxpayers,e.g.via the free collegemovement,financial aid policy (both grants and loans),or the Covid-19 student loan repayment pause forloans guaranteed by the federal govemment.Interestingly,individual educational insurance policies where students pay a premium to protect them-selves from income risk are either not well developed or are non-existent.2 One reason for the low preva-lence of educational insurance in post-secondary markets may be low demand.There is evidence that stu-dents can be over-optimistic about future earnings (e.g.Baker et al.(2018)),failing to adequately considerinsurance risk at the time of enrollment and financing because of difficulty in predicting future incomes ac-cording to major (Arcidiacono et al.,2012;Baker et al,2018;Conlon,2021).On the supply side,anotherexplanation could be the presence of adverse selection (Einav et al.(2023))and moral hazard (Zweifel andManning,2000)in insurance markets.IClosest to our setting,individuals purchase insurance to mitigate financial losses (e.g.Arrow,1963),buffer against incomeshocks (e.g.Chetty and Szeidl (2007)),and for a variety of other reasons.Guiso and Paiella (2008)document the increasing propensityof households to hedge against labor income risk in particular,indicating a rising awareness of employment/income uncertainties.Inthe case of financial markets,diversification,including the use of derivative instruments like futures and options,remains a primarystrategy for risk management in the face of uncertain economic outcomes (e.g.Bodie(1994):Goyal and Welch (2007)).2Throughout this paper,we will assume that the primary fom of insurance in post-secondary education is against the risk of lowor uncertain income,and will refer to this as "low income insurance"or "educational insurance."2Our paper makes a unique contribution to our understanding of student demand for educational insur-ance and the potential relevance of adverse selection in the viability of low-income insurance in educationmarkets.Students who are unsure about their prospects may demand insurance to protect themselves againstdownside labor market risks.Adverse selection is related but different:the insured use information that theycan easily conceal from the insurance company to take advantage of the insurance's downside protections.Our major contribution is a framing experiment used to tease out insurance demand;our survey allows usto see concealed information unavailable to the hypothetical insurer to test for adverse selection.Usingthe experiment coupled with the survey,we can test how framing affects a student's demand for educationinsurance and see if students use concealed information to take up the protections at different rates.We partnered with a large,non-profit university (hereafter,The University)that typically serves non-traditionally aged students who are often working adults.We conducted a randomized survey lab experi-ment with 2,776 students to understand their preferences over different educational financing choices.In the survey,students were asked to choose between a hypothetical federal student loan with the optionof an income-driven repayment(IDR)plan and a hypothetical income-share agreement (ISA).Both optionsprovided information on monthly loan payments that are waived for very low incomes and otherwise arecapped to a fixed share of an individual's income,with markedly different implementation and paths forsatisfying the loan obligation.In the experiment,students were randomized into two equal groups and,similar to Abraham et al.(2020),the presented hypothetical options differed in temms of level of detail provided for each of thechoices.The first group was shown descriptions of the student loan with option of IDR and the ISA with arisk-neutral framing that explained the differences in monthly payments,general structure of the loan,thebaseline payment terms,and the source of funding.The terms of the student loan with IDR and the ISAwere set to be actuarially equivalent.We exposed the second group-our treatment group-to the samedescriptions of the student loan with option of IDR and the ISA,but with an additional emphasis on theinsurance features (nature of the income contingency and maximum repayment term)of the two financingoptions.There are many differences between federal student loans with IDR and ISAs,and many reasons whydifferent borrowers might prefer one over the other.With federal student loans,borrowers who do wellin the labor market will pay less in total by paying fixed monthly payments for the minimum number ofyears (120 payments,or 10 years with no gaps in payment).Since there is no prepayment penalty forfederal student loans,they can also be paid off faster than scheduled and may be particularly attractive tostudents who expect consistently high eamings after college.To access the income contingency,borrowersmust follow a series of administrative hurdles in order to qualify for reduced monthly payments capped at a3certain percentage of their income,paying nothing if their income falls below a set threshold,but potentiallyextending their term up to 20 years compared with the standard repayment plan.3 With an ISA,borrowers'monthly payments are set as a pre-agreed share of income by design,and the repayment term is typicallyextended to a lesser degree than IDR due to months of non-payment,making an ISA a potentially attractiveproposition for borrowers with persistently low or variable eamings.On the other hand,there is no wayto "refinance"out of an ISA and borrowers who end up earning high incomes will pay up to a multipleof the original loan amount,described in our experiment.Finally,borrowers may have preferences overborrowing from the govemment versus a private lender.We find that students have a significant preference for the built-in income insurance in the ISA andthat our insurance framing greatly increases the demand for the hypothetical ISA-by about 10 percentagepoints,or 43 percent.Importantly,there is limited heterogeneity in treatment to be found along demo-graphic,academic,or financial lines for students in our sample.The insurance framing has,by far,thelargest effect on take-up.Our results suggest that students are not necessarily thinking about income riskor about the potential benefits of educational insurance when they choose how to finance their studies,butthat educational and loan providers can help make the potential need for educational insurance salient forborrowers by thoroughly explaining the costs and benefits of such insurance.Our survey and follow-up questions also allow us to characterize how adverse selection may enter theeducational insurance market (Herbst and Hendren,2021).3 The survey allows us to solicit informationfrom the student that is unavailable to the ISA originator.Students may be confident about their incomepotential but can easily conceal this information from financing providers who do not have the ability toprice discriminate (i.e.must charge the same interest rate or income share to all).In such an environment,students expecting low incomes will sort into the ISA while students expecting high incomes will opt for atraditional loan.Educational insurance that looks more like an ISA will not be a sustainable policy choiceif students who achieve significant returns to college systematically choose student loans.Overall,thereis less evidence suggestive of adverse selection across a variety of variables than we supposed ex ante.Employment uncertainty,for example,does not appear to influence take-up.However,we do find strongsuggestive evidence of adverse selection based on likelihood of future incomes being low.To further test for adverse selection,we ask several follow-up questions to investigate how students3Recent policy changes around the Saving on a Valuable Education (SAVE)IDR plan simplify some of these processes forfederal student loans,but the income protection is still far from built in.Although some currently available IDR plans offered by theDepartment of Education extend the repayment term to up to 25 years,we wanted to keep the comparison simple for borrowers andchose the (modal)maximum term of 20 years.4The preregistered baseline variables for heterogeneoustreatment effects included race/ethnicity(Black,Hispanic,white).gender(indicator for female respondent/ecipient),household size,age(median split),marital status,risk aversion.5Since we cannot follow students after the survey,we cannot shed light on potential moral hazard from the availability of insurance4might change their answers if the offer terms were modestly different.After their initial choice between astudent loan and an ISA,we offered students who originally selected a student loan with IDR an actuarially-equivalent altemative ISA with a lower income share and a longer term.If a student maintained theiroriginal choice of student loan in the second round as well,we then offered them another alternative ISA inthe third round-this time with a higher income share and a shorter term than the original ISA.To studentswho originally selected the hypothetical ISA,we separately offered both alternative ISAs at the same time.We find that both original ISA choosers and original student loan choosers were equally likely to switchto the longer term ISA,with 18%of respondents selecting the longer term ISA over their original choice.Interestingly,respondents who originally chose the ISA were considerably more likely (61%)to choose theshorter term ISA compared with the respondents who chose the student loan with IDR in both the first andsecond rounds (17%).We further find that treated students who originally chose the student loan were 5.1 percentage points(17%)more likely to choose the ISA option with a lower share and longer temm.The treatment effect forthose offered the alternative ISA with shorter term and higher share is not statistically significant.Forstudents who chose the original ISA in our base experiment,treated students were 8.6 percentage points(15%)more likely to choose the altemative ISA option with a higher share and shorter term.We find nosignificant treatment effects on switching toward the lower share and longer term ISA for students whooriginally chose the ISA over the student loan with IDR.Overall,our results suggest that the insuranceframing helped reinforce student preferences over shorter maximum repayment term(12 years for ISA v.20 years for student loan),and that students selected altemative ISA contracts in our follow-up questions ina way that reflected their stated preference between the initial choice.Separately,we asked all students whether they would select a student loan if there were a 20%chancethat the $10,000 loan they borrowed would be forgiven.We find that students who switched from a loanto an ISA in the second round were 6.4 percentage points more likely to switch back to a loan when of-fered the chance of student loan forgiveness.Conversely,when students who picked the original ISA wereoffered a loan with a chance of future debt forgiveness,the prospect of future balance reduction decreasedthe willingness/likelihood of switching back to the federal student loan.The students who switched to anISA in the second round are marginally attached to the ISA and may be easily induced to switch betweenthe two financing choices given relatively small changes to terms,while the original ISA choosers appearto be more set in their ISA preference.Taken together with our results on student preferences over alterna-tive ISA variations compared with a student loan with IDR,our study contributes to the understanding ofoptimal design of loan products with income insurance features with regard to both upside protections (likemaximum term or total payment amount)and downside protections(like income share).Though focused on educational insurance markets,our paper contributes to other lines of research,including the literature on financial aid,education finance,and student debt.As the cost of higher educationhas risen and the purchasing power of public subsidies have fallen along with public financial support touniversities (Webber,2017),families have had to incur debt or forego consumption to afford post-secondaryeducation.Recent research has emphasized the burden that student loans place on students (Chakrabarti etal.,2020)-including on their other consumer spending (e.g.Mezza and Sommer,2015),"life milestones"(Mezza et al.,2020),and educational outcomes (e.g.Black et al.,Forthcoming,Denning and Jones,2021).Because the monthly payment is proportional to income,education insurance such as IDR and ISAs canhedge against the adverse effects of student loans.As such,take-up of such products,particularly amongpopulations where student loans have had adverse effects (e.g.students at technical or public regionalcolleges with higher variance in college outcomes),is important.Many families do not apply for aid-meaning they do not complete the required financial aid forms-because of a lack of information or uncertainty of eligibility (e.g.Kofoed (2017),Bettinger et al.(2012)).Even for families that apply for aid,the protection of some assets within the Pell eligibility formula leadsto less financial aid eligibility for students from disadvantaged families (Levine and Ritter,2023)resultingin higher student loan burdens and decreased access to selective institutions.Forms of built-in educationalinsurance are potentially more attractive to these students,as they automatically reallocate some of the riskfrom the student to the provider and may reduce uncertainty around financial aid eligibility.Additionally,our research contributes to the behavioral literature on student take-up of financial aidprograms under varied framing.Abraham et al.(2020)and Marx and Turner (2019)demonstrate thatframing matters for government-sponsored IDR plans and traditional student loan take-up,respectively.Inthis literature,researchers manipulate the students'norms,the temms,risk,and the costs communicated tostudents with respect to specific financial instruments.Our paper contributes to this discussion by showingthat students prefer income contingent financing when we emphasize the built-in educational insurance ofthe ISA,with treatment effects for the insurance framing comparable in magnitude to Abrahamet al.(2020).The lessons from our study are applicable to the design of any income-contingent education financingproduct and are particularly salient to ongoing policy discussions around the Department of Education'sincome-driven repayment plans for federal student loans.Our paper is organized as follows.Section 2 reviews students'college financing and the prospectfor education insurance in financing education.Section 3 details the experimental design of our researchquestions.Section 4 lays out our empirical strategy and elaborates on the data collection.Section 5 provides6Cox et al.(2020)examine why students don't choose IDR when they are worried about future income expectations.Theyconduct a laboratory experiment where they provide information about IDR and default students into the plan.They find that extrainformation and correct defaulting does increase enrollment.6empirical results.Section 6 offers concluding remarks and policy considerations.2 College Financing and Educational InsuranceThis section describes borrower labor market expectations and available (student loan with IDR)and rel-atively novel (ISAs)higher education financing options with income insurance that motivated our exper-iment.In Section 2.1,we describe borrowers'income/employment trajectories and potential risks anddisruptions to future income and employment.We then proceed to explain the mechanics of an IDR optionfor a traditional student loan in Section 2.2 and the typical ISA in Section 2.3.In Section 2.4,we discusshow the features of the two financing options might influence choices between them and which types ofborrowers might respond to which incentives.Finally,Section 2.5 discusses the motivation behind ourexperiment and the comparison we offered to students in our study.2.1 Students'Educational Risks,Earnings Trajectories,and Repayment ShocksUntil recently,students and parents typically repaid government student loans in fixed monthly paymentsover a given repayment period,akin to a traditional mortgage loan(Karamcheva et al.,2020).This paymentremained constant regardless of age,income,employment status,or family situation.Most non-governmentlenders have offered private loans with a standard,mortgage-style payment schedule,though select lendersare beginning to offer or contemplate alternative options.Some 95%of outstanding student debt is guaran-teed by the federal government,so repayment plans designed and offered by the Department of Educationdominate the set of choices available to students.It is important to consider risk to the returns to college attendance (including borrowing for that atten-dance)when thinking about future income and employment prospects for students(Webber,2016;Balakr-ishnan and Cynamon,2018;Hendricks and Leukhina,2018;Akers,2021).Perhaps the largest risk factorto the repayment of educational debt that students face involves the risk of non-completion.Historically,6-year completion rates have hovered around 60%,and are even lower for nontraditional college studentsand non-selective institutions (Bowen et al.,2009).Financial circumstances,lack of academic prepared-ness,and a host of academically orientated challenges may put students'financial investment in college atrisk.Additionally,there are "life"risks that students face,including emergencies arising from physical toemotional health to family circumstances.Adult learners,in particular,report that child-care emergencies,children's health,and even transportation emergencies can derail their educational careers(Markle,2015).Even for completers,risks to income and employment are many.The average financial return for themedian graduate of a 4-year college or university is large,and handily outweighs the implicit and explicit>costs of attending college,which is why enrollment in a postsecondary program of study makes sense formost students ex-ante.But ex-post,retums are heterogeneous across many dimensions including major,institution type,and institution prestige.Since student populations particularly at risk of low or negativereturns to college enrollment tend to skew toward vulnerable groups,addressing the riskiness of collegeattendance with product/program design and effective public policy is imperative.Borrowers also face a variety of income shocks during repayment,such that repayment burdens can varywidely for individuals with variable or uncertain income and/or employment (Chapman and Lounkaew,2015;Chapman and Dearden,2017).Borrowers may face temporary repayment challenges (e.g.due toperiods of unemployment or underemployment)or chronic repayment struggles due to low incomes (e.g.because of degree non-completion,or degree/major with poor financial return on investment).Fixed payments over a 10-year period for borrowers who recently completed or dropped out of a pro-gram of study may not be optimal given typical earnings trajectories,either.For most borrowers,studentloan debt service ratios (i.e,scheduled payments as a share of a borrower's income)are typically greaterearly in the repayment term,when a borrower's income is lower.This is particularly true for student loanborrowers with little work experience upon entering repayment,for borrowers who typically begin repay-ment in lower paid early-career positions but ultimately earn substantial amounts (e.g.,medical doctors),and for borrowers with degrees in majors that traditionally have steep earnings trajectories (e.g.,biology).Considering all of these factors,standard repayment plans with fixed scheduled monthly payments maybe burdensome for borrowers and poorly suited for a setting with myriad risks to income and employment.2.2 Income-Driven Repayment Plans for Federal Student LoansIn response to these earnings patterns,repayment shocks,and increasing debt service ratios,the Depart-ment of Education expanded income-contingent repayment programs (sometimes referred to as income-driven repayment,or IDR)for federal student loans.IDR plans reduce student loan payments to 5-15%of discretionary income,defined as the amount of adjusted gross income (AGD)above a multiple of theFederal Poverty Level (FPL).As of the time of our experiment,the dominant IDR plan (and one on whichour student loan with IDR option was modeled)was Revised Pay As You Earn (REPAYE)plan.UnderREPAYE,borrowers owed 10%of income over 150%of the FPL for up to 20 (undergraduate loans)or25(graduate loans)years.The newest IDR plan introduced in 2023,the Saving for a Valuable Education(SAVE)IDR plan,sets scheduled payments to 5-10%of income over 225%of the FPL.As of 2019,about35%of borrowers with federal Direct student loans enrolled in one of the several IDR plans offered bythe Department of Education (Trends in Student Aid,2019),with the rest ineligible for IDR (e.g.,parent8borrowers)or preferring to remain with the standard plan.A borrower's payment in an IDR plan is defined below:rDIit-1 if DIit-1>0where last year's discretionary income is DIit-1=AGIit-1-mFPLt(n),n is the applicant's familysize,m E{150%,225%},and r E 10.05,0.10,0.15}.The IDR obligation is satisfied when a)the originalbalance and accumulated interest are repaid,or b)the borrower has reached the maximum repayment periodof 20 or 25 years (depending on the particular IDR plan),whichever comes first.By design,an IDR planretains a balance-tracking feature,such that borrowers whose IDR payment is less than the monthly interestexperience interest capitalization and can see their balances grow (even balloon),as frequently reported inthe popular press.Again,the hypothetical student loan with IDR in our experiment is modeled after the REPAYE plan,such that m =150%*FPL(n).r =0.10,and the maximumrepayment period is 20 years.We note that theequation above determines the maximum IDR payment,and that a borrower's payment in a particular monthmay amount to less than this maximum payment,such that the IDR option acts as insurance against lowincome at the potential cost of a higher aggregate payment amount and/or an extended repayment periodrelative to the 10 years in the standard plan.Yet,enrollment rates in these repayment plans remain low for myriad reasons such as administrativehurdles,poor design,and servicer misconduct (e.g.Mueller and Yannelis,2022).Herbst,2023 uses ran-domized variation in loan servicer outreach to find that enrollment in an IDR plan reduces student loandelinquencies by 22 percentage points and decreases outstanding balances within a year of take-up.Manystudents do not qualify for federal student loans-perhaps because they have exhausted the federal life-time undergraduate borrowing limit (approximately $30,000),or because they are ineligible for federalloans (e.g.due to parental income/assets,due to attending a non-eligible institution,or due to not being UScitizens).Other students (and their parents)take out loans that are ineligible for IDR altogether.2.3 Alternative Income-Contingent Financing:Income Share AgreementsOne alternative to student loans are ISAs,or income share agreements.Both states and institutions haveexperimented with ISAs in the past decade.ISA providers claim to fill funding gaps faced by studentsand to push programs to align incentives with students because institutions receive repayment as graduatessucceed in the labor market because repayment rates are dependent on students'post-college employment9