In e-commerce, consumers’ return of unwanted goods is a growing logistical problem for retailers. Research by HKUST’s Man Yu and collaborators shows how third-party insurance for the cost of product return promises to make the process more sustainable as the volume of online sales continues to increase.

Products bought online are returned more often than those purchased in stores, as online customers are less able to assess quality before they pay. Returns incur monetary and hassle costs, and how to optimally share this burden is a crucial question in e-commerce. Yu and her co-authors studied a market in which a third-party insurer offers return insurance—underwriting the cost of returns, for a premium. It is noted that “return insurance, in its essence, is a cost-sharing agreement among an insurer, a retailer, and the consumers.”

In this model, consumers choose between a high-quality and a low-quality retailer. Online buyers may not know the basic quality of the products on sale, and can never be certain whether they will arrive in good condition. To mitigate this information asymmetry, consumers make informed guesses about products—not only from the prices but also from whether the retailers offer return insurance.

It is unclear a priori how retailers, consumers, and insurers should behave in such a market—or whether they all benefit from the existence of return insurance. Indeed, as noted, “despite the potential benefits of return insurance, not all retailers participate.” In fact, the study found that low-quality retailers are more likely to be incentivized to offer insurance when consumers do know about product quality, whereas their high-quality competitors favor insurance more when product quality is private information. In the latter case, return insurance is particularly favorable when there is a large quality gap between retailers or consumers are skeptical about quality.

For retailers, a key reason why offering return insurance can be optimal in this model is that it can act as a quality signal, enabling them to plausibly communicate information that consumers cannot directly access. The insurer, as a self-interested third party, can amplify this effect by making the signal both costly and hard to mimic, a case of “double marginalization, which strengthens a signal’s differentiating power.” Nonetheless, the entry of insurers into the market is not always good for retailers—under some conditions, both retailers are worse off than if insurance were not an option.

For the insurer, the workload of processing insurance should be minimal. Despite this, selling insurance is only favorable when there is information asymmetry regarding quality, and then only when it is sold to retailers—offering return insurance to consumers is never profitable. Return insurance often benefits consumers, as it can reduce the risk when making an uninformed purchase, push prices down via signaling effects, and take the hassle out of returns. Some of these theoretical findings were confirmed by real-world data.

The authors believe that return insurance will spread beyond China. “Given the megascale of online returns, seller-paid return shipping may not be sustainable in the long run. Understanding that free return is not always realistic, many consumers are willing to share the return shipping cost, as revealed by [recent] research.” The study provides theoretical and empirical justification for the role of return insurance in reshaping this aspect of e-commerce.