Via MR, this article describes the obstacles to a market for private unemployment insurance.  Why is it not possible to buy an insurance policy that would guarantee your paycheck (or some fraction of it) in the event of unemployment?  The article cites a number of standard sources of insurance market failure but most of these apply also to private health insurance, and other markets and yet those markets function.  So there is a puzzle here.

The main friction is adverse selection.  Individuals have private information about (and control over!) their own likelihood of becoming unemployed.  The policy will be purchased by those who expect that they will become unemployed.  This makes the pool of insured especially risky, forcing the insurer to raise premiums in order to avoid losses. But then the higher premiums causes a selection of even more risky applicants, etc.  This can lead to complete market breakdown.

In the case of unemployment insurance there is a potential solution to this problem which borrows from the idea of instrumental variables in statistics.  (Fans of Freakonomics will recognize this as one of the main tools in the arsenal of Steve Levitt and many empirical economists.)  The idea behind instrumental variables is that it sidesteps a sample selection problem in statistical analysis by conditioning on a variable which is correlated with the one you care about but avoids some additional correlations that you want to isolate away.

The same idea can be used to circumvent an adverse selection problem.  Instead of writing a contract contingent on your employment outcome, the contract can be contingent on the aggregate unemployment rate.  You pay a premium, and you receive an adjustment payment (or stream of payments) when the aggregate unemployment rate in your locale increases above some threshold.

Since the movements in the aggregate unemployment rate are correlated with your own outcome, this is valuable insurance for you.  But, and this is the key benefit, you have no private information about movements in the aggregate unemployment rate.  So there is no adverse selection problem.

The potential difficulty with this is that there will be a lot of correlation in movements in unemployment across locations, and this removes some of the risk-sharing economies typical of insurance.  (With fire insurance, each individual’s outcome is uncorrelated with everyone else, so an insurer of many households faces essentially no risk.)