Failure Insurance

Yesterday’s Chronicle of Higher Education reports on a working paper that was presented in Atlanta last week at the annual meeting of the American Economic Association. Chatterjee and Ionescu state that the dropout rate among U.S. college students is between 33 and 50 percent. In a theoretical framework, the authors examine whether insurance against college-failure risk can be offered, taking into account moral hazard and adverse selection. They find that optimal insurance raises the enrollment rate by 3.5 percent, the fraction acquiring a degree by 3.8 percent and welfare by 2.7 percent. In practice, students who drop out would get a portion of their student loan reimbursed.

In the U.K., by contrast, there is no risk associated with “taking out a student loan but failing to earn a degree”. As mentioned on this blog before, the income-contingent loan scheme in the U.K. works as follows:

- repayments do not start until April of the year after students have completed their course
- repayments do not start until the student is earning more than 15,000 pounds
- the repayment is 9% of gross salary
- the repayment is transacted as an automatic deducation (through PAYE though this could as easily be a direct debit)
- there is no particular schedule for clearing the debt, but, if it has not been cleared 25 years after repayment began, or if the student turns 65 years old —- then the remaining debt will be cancelled

Chatterjee and Ionescu were interviewed in the Chronicle article and asked “Why could an insurance system be superior to the kind of income-contingent repayment schemes that Milton Friedman favored?” The authors responded that the insurance 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. 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).”

It appears that the U.K. student loan scheme avoids any instance of the moral hazard problem that Chatterjee and Ionescu are concerned about. With the repayment set at 9% of gross salary, a graduate could lower the level of re-payment by deliberately earning a lower income. However, deliberately earning a lower level of income would also reduce the graduate’s level of consumption. It appears that there is no disincentive to maximise earnings for graduates that avail of the U.K. student loan scheme. Finally, college-entry may be more likely under income-contingent loan schemes, such as the U.K. student loan scheme. In a “failure insurance” scheme, such as the one outlined by Chatterjee and Ionescu, students who drop out only get a portion of their student loan reimbursed. So they end up in the position of having no qualification, but still paying off some amount of debt.

* Readers may be interested in the Student Lending Analytics Blog.