First American

The REconomy Podcast™: Lemons and the Economic Theory Behind Insurance

In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain the connection between lemons and the economic theory behind insurance.

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Listen to the REconomy Podcast Episode 54:

“But the point here is that we use insurance to protect ourselves against the hidden risks in the home. Think of the home as a potential lemon. How do you protect yourself as a buyer from this lemon house? Well, you get insurance.” – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Hello, and welcome to episode 54 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, happy almost-New Year. This is our last episode of 2022.

Mark Fleming - Hi, Odeta. Happy almost-New Year to you as well. I assume we're discussing something special for our last episode of the year?

Odeta Kushi - We sure are, but it might not be what you think. In fact, I don't think we'll mention the Federal Reserve or housing affordability at all in this episode.

Mark Fleming - You know, dare I say this? But that's a relief. I think we've discussed those topics more than enough over this past year. And I'm certain we will continue to cover them next year because it's not done. So, what will we be covering in this episode?

Odeta Kushi - Well, it's funny, you mentioned what we'll cover because the topic of today's podcast has to do with coverage.

Mark Fleming - Wait, witty plays on words. That's my schtick. Is this a harbinger of the year to come?

Odeta Kushi - Don't worry, you can keep that schtick next year. I'm not taking it from you.

Mark Fleming - Whew. I'm sure our listeners are happy to hear that, or maybe not. But I digress. Coverage as in insurance?

Odeta Kushi - Exactly. And before we lose you listener, I promise this will be interesting. Today, we're going to be talking about insurance and lemons.

Mark Fleming - Yeah. And that's how you keep them interested. But I see where you're going with this. And it's about time we talk about insurance, because after all, we do work for a title insurance company.

Odeta Kushi - That's right. But that's not the only reason why the insurance discussion is important. Insurance brings up the topics of asymmetric information and adverse selection. Don't worry, we'll define those in a bit. And those are market situations that appear everywhere. But first, let's just start with a basic definition of insurance.

Mark Fleming - But you were just referring to losing listeners. So, yeah, let's just talk about those things. Who doesn't like listening to a discussion about adverse selection and asymmetric information, other than two economists doing a podcast at the end of the year? Yeah. But we're gonna give it a whirl anyway. Insurance is just a way to manage all kinds of potential risks in life. When you buy insurance, you're purchasing the financial protection against unexpected health events, life events, car accidents, or other kinds of accidents, and in our case, specifically, a risk of losing your property ownership rights.

Odeta Kushi - See, I told you we'd bring it back to real estate, at least. Even if it's not the Fed or housing affordability.

Mark Fleming - We can't resist.

Odeta Kushi - Exactly. And you know, insurance could protect you from future events, as we all know it to do, but it can also protect you from the past.

Mark Fleming - Finally, I've been trying to work one of these in for the last few episodes, something to do with Charles Dickens, right? The insurance of Christmas, past, present, and future.

Odeta Kushi - You got that into the script today. Congratulations. I know you've been trying for a while. Well, we'll talk about what we mean by all of this in a second. But first I want to talk about asymmetric information and adverse selection. And to do that we have to talk about lemons.

Mark Fleming - And exciting. This is not referring to the delicious citrus fruit, is it?

Odeta Kushi - That's right. That's right. It's actually referring to a famous 1970 paper by economist George Akerlof entitled, "The Market for Lemons: Quality Uncertainty and the Market Mechanism." If you've ever taken an economics course, chances are this paper has come up. But would you care to give us a short summary, Mark?

Mark Fleming - Nothing like an end-of-year podcast to reference an over 50-year-old paper. But it's a good one.

Odeta Kushi - It is.

Mark Fleming - The paper explains how the quality of goods traded in a market can worsen in the presence of information asymmetry. That means sort of people knowing more about their thing than the other side. This sort of lack of balance of information between buyers and sellers, leaving only lemons, as in the dud car type of lemon, because the paper used the used car market -- that's a tongue twister -- as the example for their analysis.

Odeta Kushi - But the paper has relevance beyond just the used car market. The economic theory is actually pretty simple. If buyers are unable to distinguish between a high-quality good and a lemon, they're only willing to pay a price the averages the value of those extremes. The seller is the only party armed with the information to differentiate between the two, right? Because the seller knows whether they have a lemon or not. And, given the buyers price position in this asymmetrical relationship, will only sell when they hold lemons. The seller with a high-quality product will leave the market since buyers are unwilling to pay a premium out of fear of being stuck with a lemon. This is all out of that asymmetric information problem.

Mark Fleming - Right. And, eventually, as enough of the sellers that have the high-quality good leave and the average quality on the market decreases, so does the average willingness to pay of the buyer because there's more lemons out there, so you're more likely to get a lemon. The average price sort of goes down, leading to an ever bigger decrease in higher quality goods in the market. Because as it gets worse and worse, there's less incentive for that higher quality good seller to participate, you get this sort of vicious cycle. Therefore, the uninformed buyers price creates this adverse selection problem that drives the premium good out of the market entirely.

Odeta Kushi - Another definition here, adverse selection. Adverse selection also occurs because of information asymmetry. So an example is the tendency of those in dangerous jobs to purchase life or disability insurance, where chances are greater that they will collect on it. So like a racecar driver is probably a riskier career than let's say, an economist.

Mark Fleming - You don't say. It's pretty safe sitting here at our desk recording podcast episodes. Let's talk about all of that in the context of health insurance, something I think we're all a lot more familiar with. A person who is sick has better knowledge of their medical needs, and anticipated medical costs, which gives them that asymmetric information advantage in purchasing health insurance.

Odeta Kushi - And, in response, private health insurers try to avoid the adverse selection problem by screening customers to eliminate high medical users, and then establishing higher premiums to cover perceived financial risk.

Mark Fleming - So, when we talk about health insurance, we're insuring the present or the future, you get health insurance to make sure that if you're sick or you get sick in the future, you have the insurance to cover your medical bills. But, Odeta, you had mentioned insuring the past?

Odeta Kushi - Yes. And that's where title insurance comes in. First, if you are not familiar, we'll answer the question. What exactly is title insurance?

Mark Fleming - And since I seem to be responsible for definitions, I guess I'll go.

Odeta Kushi - I didn't even have to ask you. Nice.

Mark Fleming - One last explanation. See, I avoided the urge, one last explanation in 2022. So, when a property is financed, bought or sold, a record of that transaction is generally filed in the public record. Likewise, records of other events that may affect the ownership of a property, like liens or levies on the property are also filed. When you buy title insurance for your property, a title company is searching those public records to find and remedy, if possible, any prior records that could affect that ownership right.

Odeta Kushi - Well, then I'll help with the Econ-splaining too. It's my Christmas gift to you.

Mark Fleming - Aww, shucks, thanks, Odeta. That's so sweet.

Odeta Kushi - Thank you, that is me. So some risks, such as title issues due to filing errors, forgeries, or undisclosed heirs, are difficult to identify. So, after the title company finishes its searching, it also provides a title insurance policy that will help protect the buyer from a variety of issues that might be uncovered later, aka in the future.

Mark Fleming - That's right. And, if you take out a mortgage loan when you buy your property, then your lender will also require a loan policy of title insurance. And this is slightly different, this protects the lender's right to foreclose, if necessary, on your property until you pay off that loan or you refinance. On the other hand, the owner's policy is protecting you, the owner with title insurance for your ownership rights in the property.

Odeta Kushi - Undiscovered defects in the past are the underlying cause of most title insurance claims, rather than events that could occur in the future. So, basically, in title insurance, we're insuring the past. Issues could arise long before you bought your property to deprive you of ownership or your right to use or dispose of it. And you don't want to pay the potentially high cost of defending your property rights in court. So, what would be the lemon in this instance, Mark, when we're talking about title insurance?

Mark Fleming - Yeah, bringing it back to lemons. Well, the more hidden things there are -- those asymmetric information things that the seller knows about the property that are in the past -- the more lemony it is. For example, back taxes on a property could make your home more lemony. I think we might be defining a new economics term of insurance here.

Odeta Kushi - Lemony, yeah, add it to the Econ textbooks. And, of course, we know there are low probability, high severity fraud risks that could occur as well.

Mark Fleming - Oh, that's right. Let's say you just bought a house, but you wake up one morning to a knock at the door. And the person at the door is a grandmother who's claiming to be the owner of the house that you just bought. She wants to know why you're in her house. You then go and discover, through some research, that the woman who signed your deed was, in fact, not the grandmother who own the house, but the girlfriend of a person who fraudulently recorded a transfer of ownership from the grandmother to themselves. We sort of made this up, but you get the point.

Odeta Kushi - Well, I mean, it sounds crazy, but this has actually happened. So, in this instance, fraud was committed in the sale of the property, and now you don't have the good title to your home, and the grandmother probably wants her home back.

Mark Fleming - Yeah, I think that certainly fits the low-probability, high-risk scenario that one might like insurance for.

Odeta Kushi - Right? I mean, people are generally risk averse and pay for insurance to protect against this type of loss. This is all based on utility theory, by the way, but I won't go into detail about that on this episode.

Mark Fleming - Yes, let's not attempt any utility theory here. Let's talk about it more generally. If someone is risk averse, they don't like risk in general, they're willing to pay something for the insurance, maybe more for the insurance to prevent what they want to avoid, rather than take the chance of having that loss. What they're willing to pay for this security that the insurance gives them, or the reduction of uncertainty that the insurance gives them, is called the risk premium, or the amount above their expected loss, or the expected payout that might happen in the event of it, on the insurance policy that someone is willing to pay to have insurance. In other words, the more risk averse you are, particularly in that high-severity, low-probability event, the more you're willing to pay to insure yourself to avoid it.

Odeta Kushi - And I'm going to just stop us there because I think we're moments away from postulating a utility function and computing an expected utility. And I won't, I won't allow us to go there. But the point here is that we use insurance to protect ourselves against the hidden risks in the home. Think of the home as a potential lemon. How do you protect yourself as a buyer from this lemon house? Well, you get insurance.

Mark Fleming - Exactly. Bringing it full circle, back to the lemons problem.

Odeta Kushi - That's right. Well, I hope you all enjoyed this slightly econ-wonkier episode of the REconomy podcast. We hope everyone has a safe and wonderful new year. You'll hear from us in 2023. We've got lots planned for this next year, including some special guests. And, as always, thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.