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Insuring College Dropouts: A Bold New Idea From the Philadelphia Fed

5 years ago
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What if college undergraduates could have their student loans paid off in the event that they failed out of school?

That's the question Satyajit Chatterjee and Felicia Ionescu attempted to answer last November in a paper released by the Federal Reserve Bank of Philadelphia. Chatterjee, a senior economist at the Philadelphia Fed, and Ionescu, a professor of economics at Colgate University, proposed an insurance model that would protect against the risk of college failure -- a scheme that would partially reimburse the cost of outstanding student loans for dropouts.

"We wanted to see if there was a possibility to take the edge off the risk of student loans," Chatterjee said. "When Felicia and I saw the dropout rate, as well as the percentage of college dropouts who still have huge debts, we were shocked. And that's when we realized that this would be an issue that would affect a large number of people."

In addition to providing students with a safety net in the event of failure, the proposals in the Philadelphia Fed paper aim to raise college enrollment and completion rates. More high school graduates would enroll in college, the paper argues, if they were not discouraged by the financial risk of taking out a student loan.

Failure insurance, according to Chatterjee and Ionescu, would also provide the nearly 50 percent of American college students who drop out with an additional incentive to stay in school, since they would not have to worry about accumulating heavy debt in the event that they failed to earn a degree.

"I think it is an idea worthy of consideration," Kevin Stange, a professor of public policy at the University of Michigan and an expert on social insurance programs, said in an email message. "To the extent that failure insurance would make students more comfortable taking on educational debt, there could potentially be several benefits: greater enrollment, a shift towards better (and typically more expensive) colleges, greater completion, a shift towards more difficult majors, and greater use of loans as a financing mechanism."

Under the terms of the program, students would pay into an insurance pool that would cover from 10 to 45 percent of the cost of college for each participant who dropped out. The relatively low amount of coverage is one of the policy's protections against what is known in the insurance world as "moral hazard" -- or eliminating the consequences of poor decisions.

"The forgiveness is fairly minor," Chatterjee said, "students still owe a lot of money if they don't succeed." Chatterjee and Ionescu also point out that students who dropped out would pass up on significantly higher lifetime earnings, which are available primarily to college graduates. In other words, they maintain that students would still want to work hard to pass, since failing out of college has serious long-term costs.

Though their paper has received a flurry of press in the past few months, Chatterjee and Ionescu stressed that their proposal was still a model, and there is no sign yet that the insurance program they endorse could move past the hypothetical stage. If it eventually does become a reality, Chatterjee and Ionescu argue that the ideal institutions to provide it would be colleges themselves, which, they say, could asses the risks of each student more accurately than the government or a private company.

To be sure, not all economists warmed to the idea. "I'd prefer something like more interest-free loans or scholarships," Raj Chetty, a professor of economics at Harvard University, said in an email. "The students we want to encourage to go to college are not the ones at risk of failing out, but the ones who know they would do really well but just don't have the money to pay the tuition. Failure insurance would be targeted at bringing in the students who are at risk of failing out, which is not socially productive."

Bringing down the student debt burden has long been a challenge for both American colleges and the federal government. The issue arose again last week, when Congress attached a student loan overhaul to its health care reform bill. Under the new law, which Congress passed on Sunday night, the Department of Education will act as the sole provider of U.S. student loans, ending years of government subsidies and guarantees for the private banks that have issued them in the past.

Even for students who plan on completing college, debt remains a serious concern in the uncertain American economy. "Now that there's no assurance that you will have a job after college, students are less confident that they'll be able to pay off their loans," said Jack Condon, a freshman at the College of the Holy Cross, in Worcester, Mass., who hopes to pursue a career in teaching."There's the feeling that they're investing too much in something that will not pay off in the long run."
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