Map of life expectancy at birth from Global Education Project.

Monday, April 10, 2006

It's hard work

If the long and winding tale of the recent Massachusetts health care legislation teaches us anything, it's that most people basically don't understand what exactly the heck is going on here -- and that includes state legislators and even quite a few activists who have been pushing for something vaguely defined as universal health care or universal coverage. It's always my goal here to provide the entoxicatingly delicious bite-sized chunk of wisdom that will produce immediate enlightenment about the pressing issues of the day, but when it comes to health care policy, I just can't do it. It's complicated, the standard vocabulary is misleading, a lot of different parts have to be fitted together to make sense of it all, and it's just wonkish, and boring, and it makes your head hurt, and that's all there is to it, so there.

So I've decided to take this in pieces. First I'm going to talk about insurance that isn't health insurance. The product or service we call health insurance is only partly insurance, and to the extent that it is insurance, it is unlike other insurance in very important ways. But the mere fact that we call it insurance muddles things up. So for now, let's not even talk about it. Let's talk about automobile insurance, homeowner's insurance, and life insurance.

Insurance, in the original and still most common sense of the term, is a financial instrument for spreading risk. Most people would have their lives utterly ruined if their house were to burn down, but fortunately, only a few people's houses ever do burn down. A lot of people will willingly pay a sum they can afford -- these days typically less than 1,000 dollars a year -- for the peace of mind of knowing that if their kid plays with matches and their little Blandings Castle burns down to the root cellar, they'll be given the money to rebuild. If people have a mortgage, the bank will insist that they have insurance, because they want their collateral protected. Life insurance and automobile insurance are basically similar -- they compensate you or your heirs for an unwelcome eventuality.

Liability insurance has this function, plus one more -- it protects others who might be injured by your negligence. Therefore it is also required in some circumstances, for example in order to legally operate an automobile.

Okay then. Let us suppose that Europeans land for the first time on an island in estuary of the Hudson River, kick out the local oyster gatherers, and build a city of 8 million people. Suddenly, in 2006, Fred invents life insurance, and Fred's Insurance Company enters the virgin market. Now, Fred could figure out the percentage of adults in Manhattan who die every year -- let's say it's 1% -- and sell a $100,000 life insurance policy for $1,001 dollars a year. (We'll ignore the income he makes on the money he holds on to before he has to pay out claims -- that's important to Fred but it doesn't really matter to our point.) If he sells 100 policies, he collects $100,100, and at the end of the year he makes one $100,000 payout. He's made a hundred bucks, just for sitting on his keister signing deposit slips and writing one check. Of course, he could be unlucky and have two people die that year, or be lucky and have nobody die, so he evens it out by selling many hundreds of policies and doing it for many years -- it should work out in the long run, right?

Nope. If Fred tried that, he'd be very sorry, because a whole lot of people with terminal cancer would have bought his policies, while all those twenty-somethings jogging in the park would never even consider it. If Fred wants to make money, he's got to try to figure out the individual customer's chances of kicking the bucket in the near future, and then by some combination of differential pricing and selective sales get enough people to buy policies and not die to pay him for the customers who expire.

But wait a minute -- I thought the purpose of insurance was to spread risk. Now you're charging more to the risky people, or refusing to sell to them at all. In fact, if Fred can do a very good job of predicting your life expectancy, his product will become worthless. If he knows you are going to die in exactly 3 years, 4 months, he'll charge you exactly enough to cover the cost of the payout at that time in the future, plus his expenses and his profit, minus whatever investment income he expects to make on your premiums. Your heirs would be better off if you just invested the money yourself and didn't pay Fred.

Now, the insurance industry can't precisely predict your life expectancy, but in order to compete with each other, insurers need to do the best they can. If you are young and healthy, you're going to look for a company that will sell you cheap insurance. If you know you are sick, the insurance companies better be on the lookout for you or you'll take them for everything they've got. So insurance companies need to be able to sell cheaply to low risk customers and charge more to high risk customers, or their competition will get all the desirable sales and they'll lose their shirts.

So it's fortunate for the insurance industry that they can't precisely predict people's life expectancies, or they'd put themselves out of business because their product would become worthless. At the same time, they continue to work as hard as they can at predicting individual risk in order to keep up with the competition.

This is one reason why insurance markets are highly regulated. In order to accomplish some of the social purposes of insurance, insurance companies have to be restricted from segmenting their customers as thoroughly as they can -- and actually, insurance companies appreciate those restrictions, even if they won't admit it, because their business would be much more difficult without them. It would be impossible to buy affordable homeowner's or automobile insurance in some neighborhoods, for example, if states didn't force insurers to put customers into relatively broad pools. This does have the effect, however, of making people in relatively safe neighborhoods subsidize the insurance costs of people in dangerous ones.

Sorry to bore you. Now you can entertain yourself by thinking about ways in which health insurance is similar, and different, while I prepare to discuss that very subject.

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