Signaling Quality with Return Insurance: Theory and Empirical Evidence

Abstract

This paper examines an innovative return policy, return insurance, emerging on various shopping platforms such as Taobao.com and JD.com. Return insurance is underwritten by an insurer and can be purchased by either a retailer or a consumer. Under such insurance, the insurer partially compensates consumers for their hassle costs associated with product return. We analyze the informational roles of return insurance when product quality is the retailer’s private information, consumers infer quality from the retailer’s price and insurance adoption, and the insurer strategically chooses insurance premiums. We show that return insurance can be an effective signal of high quality. When consumers have little confidence about high quality and expect a significant gap between high and low qualities, a high-quality retailer can be differentiated from a low-quality retailer solely through its adoption of return insurance. We confirm, both analytically and empirically with a data set consisting of more than 10,000 sellers on JD.com, that return insurance is more likely adopted by higher-quality sellers under information asymmetry. Furthermore, we find that the presence of the third party (i.e., the insurer) leads to double marginalization in signaling, which strengthens a signal’s differentiating power and sometimes renders return insurance a preferred signal, in comparison with free return, whereby retailers directly compensate for consumers’ return hassles. As an effective and costly signal of quality, return insurance may also improve consumer surplus and reduce product returns. Its profit advantage to the insurer is most pronounced under significant quality uncertainty. This paper was accepted by Vishal Gaur, operations management.

Commission, product quality and return policy in agency selling

“…Our assumption is in line with the literature (e.g., McWilliams, 2012; Zhang, Yu, et al, 2021). Both McWilliams (2012) and Zhang, Yu, et al (2021) assume that consumers' valuation is irrelevant to the product quality when characterizing consumers' return decisions. The production technology, the commission‐based contract and the sequence of events are similar to those in the basic model in Section 4.2.…”

“…In this section, we assume that v is irrelevant to q , which simplify our analysis. Our assumption is in line with the literature (e.g., McWilliams, 2012; Zhang, Yu, et al, 2021). Both McWilliams (2012) and Zhang, Yu, et al (2021) assume that consumers' valuation is irrelevant to the product quality when characterizing consumers' return decisions.…”

“…In this section, we assume that v is irrelevant to q, which simplify our analysis. Our assumption is in line with the literature (e.g., McWilliams, 2012;Zhang, Yu, et al, 2021) characterizing consumers' return decisions. The production technology, the commission-based contract and the sequence of events are similar to those in the basic model in Section 4.2.…”

“…Balachander (2001) considers a competitive market with an established incumbent and a new entrant, and provides an explanation for the phenomenon that a low‐quality firm may offer a longer warranty. Zhang, Yu, et al (2021) propose that the consumers view the return insurance as a signal of high quality. In contrast with these studies, we investigate the role of the commission‐based contract on the quality decision and the return policy.…”

“…Some empirical studies identify the dependency between product quality and consumer satisfaction, such as, Pirri and Mulia (2020) and Sugrova et al (2017). Moreover, a line of literature defines the quality as the consumer satisfaction probability in their analytical models, including McWilliams (2012) and Zhang, Yu, et al (2021). Following this line of literature, we assume that consumer satisfaction probability depends on the product quality.…”