November 2002 -- As human beings, we fear chaos and confusion and fight against them. We appreciate order. We celebrate reason, logic, and science because they help us bring order and manageability to our experience of reality. But no matter how rational and focused we are, we remain vulnerable to unexpected events that can throw our lives into turmoil. A slippery sidewalk, an unanticipated illness, a drunken driver, a freak storm, or (who knows?) an errant meteor. Besides, "the best laid plans of mice and men oft go astray." We need a tool to help us mitigate the consequences of uncertainty in day-to-day life, just as reason and logic help us to bring order and predictability to cognition. Fortunately, we have such a tool: it's called insurance. Insurance cannot repair the damaged or heal the sick, but it can alleviate the economic consequences of unpredictable negative events like accidents, natural calamities, and illness or death.
What is Insurance and Why Do We Need It?
"Insurance" is a financial tool with which we can replace the small risk of a catastrophic financial loss with the certainty of an affordable payment. Insurance companies help people achieve this objective by spreading and pricing risk. For example, let's say there is one chance in a million that I will be hit by a truck, resulting in a $1 million loss. That event—unlikely as it might be—would devastate me financially as an individual. I would gladly pay $2 to make the monetary part of this risk disappear. So would millions of other people. Therefore, an insurance company can profitably sell such protection, called an insurance "policy," to me and to 999,999 others for a reasonable fee, called a "premium."
The insurer promises to "indemnify" me and all other policyholders (or "insureds") if and when the insured event occurs by paying us a specified "claim" amount that restores us to our financial position before the loss occurred. If the company sells one million such policies for $2 each and incurs the anticipated single "loss" of $1 million, it makes a hefty 100 percent profit and performs a valuable public service in the process. The insureds can relax and enjoy life in the knowledge that if the worst happens, at least they are protected financially. That is called "spreading risk." But what if five of the insurance company's beneficiaries are hit by trucks instead of just one? Then the company would have collected only $2 million in premiums, but would owe $5 million in claims, a $3 million loss. To know what to charge for insurance protection, companies must "assess the risk." They must measure, record, and analyze extensive "actuarial" data on the incidence and frequency of the insurable event. In other words, they must answer the question: What is the probability that the insurable event will occur to individuals among the insured group and what will be the cost if it does? That is called "pricing the risk."
Of course, they cannot say with certainty whether you or I may be the victim, but they can say with a high degree of confidence what level of risk we face as a group of individuals. Thus, insurance makes it possible for us to "transfer risk" from ourselves as individuals to a third party, the insurance company, in a voluntary commercial relationship that benefits both parties. The insureds gain peace of mind. The insurer gains profitability.
So far so good. But what if I want to buy insurance because I know I am very likely to need it? This is called "adverse selection," and insurance companies must discourage it. Or else, what would happen if I bring more risk into the risk pool than you do? Would it be fair to charge me the same premium as you have to pay? In fact, would you even purchase an insurance product that guaranteed to give a higher return on average to other, higher-risk insureds than to yourself? Probably not.
For example, say that I am a heavy smoker and I am therefore more vulnerable than a non-smoker to emphysema and lung cancer. If I'm already sick, selling me health insurance would be like providing fire insurance to someone whose house is already in flames—blatant adverse selection. But even if I'm not yet ill, if I were to pay the same premium for health insurance as a non-smoker, I would be getting more protection for my money, dollar for dollar. That's because, as a smoker, I would be much more likely than the non-smoker to file an insurance claim for medical treatments related to my unhealthful behavior. Put another way, the non-smoker would be subsidizing my health insurance premium by paying a higher premium himself than the level of risk he brings to the risk pool warrants.
Thus, insurance companies must not only assess but also "classify" risks. They do this through "underwriting." That is, they ask questions, examine evidence, or do tests to determine the level of risk that each individual or class of individuals brings into the "risk pool," so they will know how much premium to charge each insured or group of insureds. Thus, your insurance company may examine your driving history or review your medical records before underwriting you for auto or life insurance, for example. If insurance companies failed to classify risks in this way, the whole system would fall apart very quickly.
In the example of the smoker and the non-smoker, the non-smoker—unless he's an inveterate altruist—would get smart sooner or later, drop any health insurance that punished him financially but rewarded smokers, and look for a policy that treats everyone fairly. This would have a devastating effect on the "reserve fund" that insurers must maintain and invest. Insurers need reserves to pay claims when they occur, to cover administrative costs, and, of course, to return an acceptable profit to their investors or shareholders. When non-smokers, i.e., "good risks," drop their policies and stop paying premiums while smokers, i.e., "bad risks," keep their underpriced policies, something has to give. Either the insurer must raise premiums for the remaining smokers covered by the policy to ensure sufficient reserves to pay the higher anticipated claims or the reserve fund will become "insolvent," i.e., insufficiently capitalized to pay expected claims. Either way, nobody wins.
Another beneficial effect when insurers classify and price risk accurately is to encourage positive behaviors and discourage negative behaviors. The price of insurance should alert us to the long-term cost of our decisions. When insurance is very expensive, it sends the message that our conduct or condition may be excessively risky. For example, people who have poor driving records usually pay higher auto insurance premiums, sooner or later. Their careless or drunken driving may have little or no cost for a long time. Once a traffic ticket is issued, however, it becomes part of the public record. An auto insurance company can review the public record and raise the violator's insurance rates to reflect the added risk he brings to the risk pool. On the margin, this added cost associated with carelessness or illegality tends to discourage irresponsible behavior and reward responsible behavior. Conversely, over time, if one's driving record improves, one's insurance premiums will decline once again to reflect better performance, thus rewarding improved behavior. Insurance achieves this positive social effect justly and without coercion by objectively pricing the risky behavior of individuals.
Even when our behavior is not dangerous to others or otherwise irresponsible, however, accurately priced insurance premiums still give us valuable personal information and promote fairness and equity. For example, why should a sedate philosophy professor pay the same life insurance premium as a skydiver or motorcycle daredevil? There is nothing wrong with the adventurous life, but insurance helps make sure that those who choose it take their fair share of the fiscal, as well as the physical, risk. Properly conceived, therefore, private insurance is in many ways a marvelous early warning system for us both as individuals and as a society.
Notice, finally, that insurance is different from saving, though the two are intimately related as ways of preparing for future needs. When we save, we are putting money aside for future use, normally in an account or investment that earns a return; we retain the money rather than paying it to someone else, and we get back only what we put in (plus interest or dividends). We can use savings to deal with various risks, but saving per se does not spread risks among people and thus does not require the kind of risk classification that insurance does.
Insurance and savings can of course be bundled together as products. An example is whole life as opposed to term life insurance. When you buy a whole life policy, you are not buying pure insurance; you are investing a portion of your premium with an insurance company. Most people can invest their money much more profitably through independent investment vehicles. In the same way, most managed-care health plans cover both unpredictable catastrophic illness or injury and routine, predictable medical expenses like annual checkups. In effect, managed care is a combination of a lay-away plan for routine care and insurance for catastrophic care. Bundling those functions together is generally not a good idea—though in this case government policies have pushed most people in that direction.
Why and How is Insurance Corrupted?
Well, if insurance is that wonderful, why do so many people have such a bad opinion of it? What's the "rap" against private insurance? Maybe the following comments will sound familiar: "Private insurance is heartless. It blames the victim. It punishes people for conditions that are no fault of their own." For example:
- Health insurance callously excludes anyone with a serious pre-existing medical condition.
- Home owners insurance may be prohibitively expensive for otherwise fine citizens who just happen to live in crime-infested neighborhoods.
- AIDS patients can't get life insurance, and Alzheimer's patients can't get long-term care insurance, even though these are the people who need the protection most.
Are these legitimate criticisms? No, of course not. Insurance is a business, not a charity or a welfare program. Private charity or government welfare programs may be legitimate ways to help the uninsurable, but that's a different issue. To achieve the benefits I described earlier, insurance must remain a business enterprise, motivated by self-interest, regulated by competition, and priced by objective evaluation of risks and returns. When politicians, bureaucrats, or "advocates" of one kind or another try to achieve welfare goals through private insurance—when they try to "improve" on private insurance with mandates, controls, or regulations—all sorts of unforeseen and unintended consequences follow.
Here is how it starts. In the interest of protecting consumers, someone insists that insurance should be required to cover a benefit that was previously not covered or covered only as an optional benefit for an added premium. Or, in the interest of assisting the uninsurable, someone demands that everyone should be able to buy insurance and that premiums should not exceed "reasonable" levels. Or, in the interest of helping people who are vulnerable to certain illnesses, someone wants to prohibit the collection and review of medical or genetic information by insurance companies.
Demands for politically induced insurance "reforms" like these start small and quietly. They build over time with growing support from the often small minority of individuals who stand to benefit most from the changes. Gradually, interest groups mobilize to represent the benefit seekers and to promote their claims. A relatively small number of people and organizations have a relatively intense interest in promoting laws that benefit them.
Opposition remains quiescent for two main reasons. "There but for the grace of God go I," think some. "Maybe this new law will actually help me someday." Others think, "I should not begrudge the less fortunate their getting something from private insurance companies. After all, those companies have deep pockets and, even if they pass the cost on to me, how much more will helping the needy cost me anyway?" Most people do not understand the trade-offs between a free and a controlled insurance market. Others don't care. Thus, whether motivated by self-sacrifice or the hope of unearned gain, by ignorance or apathy, most people go along to get along, supporting government intervention in the insurance industry.
All of these interventions attempt to reduce the cost of insurance protection for high-risk individuals by increasing the cost to low-risk individuals. Therefore, their purpose and effect is not to reduce risk but to spread wealth. Like other egalitarian measures, they unjustly grant unearned benefits to some while imposing undeserved penalties on others. And, accordingly, the results are destructive. There is an old saying that "you get more of what you subsidize and less of what you tax." By subsidizing high-risk behaviors and conditions while taxing low-risk behaviors and conditions, these measures have exactly the opposite effect of the benign results we attributed earlier to private insurance. They reward irresponsible behavior and punish responsible behavior, creating a downward spiral of perverse incentives.
Regulation, Welfarization, and Social Insurance
Government efforts to improve on private insurance fall into two major categories. First is the regulation of private insurance through "prior approval," restrictions on risk classification, and mandated coverage (that is, the company must offer certain types of insurance in the state if it offers any). In the second category are the "social insurance" programs that government itself provides.
The first tactics used by state regulators were prior approval of insurance rates, policy forms, or both. Historically, insurance regulation has been a state-level function with relatively little federal involvement. Insurance companies that wish to market a policy nationally must file for approval in all 50 states. Each state has different requirements, some stricter than others; the most rigid states require the use of state-mandated rates or forms. Frequently, the regulation of insurance becomes the politicization of insurance and then the welfarization of insurance. According to testimony given before Congress by Robert E. Litan, co-director of the American Enterprise Institute-Brookings Joint Center on Regulatory Studies:
Regulated rates are often distorted by political pressures in order to subsidize certain classes of drivers. The AEI-Brookings study found evidence that not only does regulation often suppress average rates, but distorts rates between different classes of drivers—keeping rates for high-risk drivers artificially low, while raising rates for lower-risk drivers. This cross-subsidization is accomplished directly through limits on rates in certain classifications…. The Massachusetts case study, for example, found that some high-risk drivers receive subsidies as high as 60 percent, requiring some lower-risk drivers to pay 11 percent more in premiums than they would pay in a competitive environment ("State Regulation of Auto Insurance," Testimony before the Subcommittee on Oversight and Investigations of the House Committee on Financial Services, August 2001).
The obvious solution to bring the market back into equilibrium is to eliminate the rate caps. That is hard to do, however, because advocates for the "disadvantaged" who live in high-risk urban areas insist that the caps favor consumers and that dropping the caps would benefit only the insurance industry by allowing it to charge higher premiums. All too often, the media accept and promulgate this argument. Thus, for reasons discussed above—vested interests for some, forced altruism for others, and ignorance or apathy for most—such insurance "reforms" tend to remain in place and other similar measures constantly gain support and adoption. I call this process the "welfarization" of insurance, that is, the transformation of private insurance by government intervention from a market-based product into a tool to improve the condition of some people in relation to and at the expense of others.
Another form of welfarization is to impose restrictions on risk classification. As explained earlier, insurers must classify kinds and levels of risk carefully to avoid "adverse selection" and to price policies accurately in accordance with the levels of risk that various policyholders bring into the risk pool. In the absence of risk classification, smokers and non-smokers, good and bad drivers, daredevils and college professors would pay identical premiums.
An example of insurance "reform" that eliminates or severely restricts risk classification is "community rating," which requires that insurance premiums reflect the average risk in a geographic region. Under community rating, the level of insurance premium for everyone is determined by adding up the cost of paying benefits for everyone—rich and poor, sick and well, responsible and irresponsible—and dividing by the total number of individuals in the covered population. To many people, this sounds like a fair and effective way to address the endemic problems of unaffordability and the uninsured, especially in the case of health insurance.
But look at what happens. Low-risk insureds soon realize that they have to pay more for insurance than was the case before community rating, and they tend to drop such over-priced coverage. High-risk insureds, on the other hand, have every reason to keep their under-priced coverage. In fact, high-risk people who were previously uninsured tend to purchase this highly attractive new insurance. Gradually, the risk pool becomes heavily weighted with people who are highly likely to file claims. Insurance companies begin to lose money and must either raise premiums to remain solvent or stop offering the coverage altogether. If the insurer raises premiums, the coverage becomes less attractive to low-risk insureds, further exacerbating the problem. Sooner or later, the only viable option for insurance carriers is to drop the policy and leave the state. The money they can collect from premiums will not cover the anticipated expenditures for claims, much less return administrative costs and an acceptable profit.
Viewed logically and analytically, this outcome seems obvious. But that has not stopped real-world regulators from imposing community rating and unleashing the inevitable consequences. For example, New York legislators mandated community rating for health insurance in 1993. The National Center for Policy Analysis summarized the effects: Consider the impact on policies sold by Mutual of Omaha, one of the largest sellers of individual health insurance policies in the state:
- Before community rating was instituted in New York, a 25-year-old male on Long Island paid $81.64 a month for health insurance, and a 55-year-old paid $179.60.
- After community rating, both paid $135.95, a 67 percent increase for the 25-year-old and a 25 percent decrease for the 55-year-old.
- Because young, healthy people began canceling policies, by 1994 both paid $183.79—more than the 55-year-old was paying before community rating was implemented—and by 1997 that community-rated premium had risen to $217.59 a month.
As a result of the departure of thousands, the uninsured population in New York City grew from 20.9 percent in 1990 to 24.8 percent in 1995, according to one report, while the national rate grew from 16.6 percent to 17.4 percent over that same period. ("Explaining the Growing Number of Uninsured," http://www.ncpa.org/ba/ba251/ba251.html
In Kentucky, the same tactic prompted 45 of 47 insurance companies to withdraw from the state's individual health insurance market. Market failure caused by government intervention then became one more reason in the minds of politicians to impose even more government intervention—a chain reaction that leads deeper and deeper into political manipulation and further dysfunction.
In addition to manipulating private insurance, government has created its own insurance programs—with equally unsatisfactory results. "Social insurance" is the idea that we should all pay the same premium, usually in the form of a payroll deduction, and that we should all be entitled to the same benefits regardless of the level of risk we bring to the global risk pool. America's Social Security and Medicare programs are social insurance systems. Both of these programs are enormously popular. Many people consider them to be unqualifiedly successful. Similar and more extensive social insurance programs in Europe have even greater popular support despite the enormous tax burden they impose on wage-earning participants.
Nevertheless, these programs are highly destructive. For one thing, social insurance is a pay-as-you-go system, and thus a Ponzi scheme. The government does not invest the payroll taxes it collects from workers in order to support their future benefits. Rather, it pays out their taxes to current retirees; when those who are currently working and paying taxes retire, they will have to depend on taxes from the next generation of workers. This system seemed to work early on when a large number of people were paying into the system while only a small number of people were drawing benefits out. But, in the future, as Europe, the United States, and the rest of the world confront a new demographic of aging, analysts say a shrinking pool of workers will be unable to support full social insurance benefits for a retiring baby-boom generation of gigantic size and unreasonably large expectations. If warnings from the General Accounting Office, the Congressional Budget Office, and dozens of independent experts are accurate, Social Security and Medicare will leave both their participants and the government worse off in the long run.
Insurance performs the critical economic functions of spreading risk and of pricing risk. If we do not price risk fairly and objectively, we end up with a system that rewards high-risk (including irresponsible) behavior and punishes low-risk (including responsible) behavior. One of the main differences between social insurance and private insurance is that, although both spread risk, only private insurance prices risk in a meaningful way. Private insurers have a legal and fiduciary responsibility to their insureds. They must price insurance coverage at a level sufficient to accumulate reserves that will be adequate to pay carefully anticipated claims rates. Private policyholders possess legal contracts, enforceable in a court of law, that assure them recourse in case of dispute, malfeasance, or insolvency by the insurance company.
Social insurance, on the other hand, offers none of these protections. Social Security and Medicare, for example, are notorious for growing exponentially beyond their original cost projections. Socially insured people have no legal recourse or protection against increases in premiums (payroll taxes), decreases in benefits (program cutbacks), or the imposition of means tests (welfarization).
In America's mixed economy, social insurance is usually considered a safety net and not a first line of financial defense. When savings, investments, pensions, and private insurance prove inadequate, we look to social insurance to pick up the slack. Unfortunately, however, the very existence of compulsory social insurance debilitates the effectiveness of these private financing vehicles. People save or purchase insurance if they perceive they are vulnerable to a large financial loss. Social insurance distorts that perception. By creating an illusion of low risk, it reduces the demand for private insurance protection.
For example, when President Lyndon Johnson signed the act that created Medicare in 1965, he stated confidently that "no longer will older Americans be denied the healing miracle of modern medicine. No longer will illness crush and destroy the savings they have so carefully put away over a lifetime so that they might enjoy dignity in their later years. No longer will young families see their own incomes, and their own hopes, eaten away simply because they are carrying out their deep moral obligations." By building up false hopes like these, Medicare effectively scuttled any hope for a private health insurance market to cover seniors. Today, the elderly spend a larger proportion of their income for health care than they did before Medicare began; Medicare has little hope of continuing to provide full benefits without major premium increases as the baby-boom generation retires; and a private insurance system to take Medicare's place has no realistic chance to develop.
The same problem occurs in other categories of insurance. Most people buy private car, fire, and life insurance. If they did not have these kinds of coverage and the insurable event occurred, they would usually experience a major loss with little direct assistance from the government. On the other hand, very few people purchase hurricane, flood, or earthquake insurance. When a major natural disaster occurs, local and national politicians jump at the opportunity of promising financial assistance of all kinds to the victims. Nothing lets a politician appear compassionate and generous without fear of criticism like a major disaster. Why buy flood insurance if the government indemnifies you with grants and loans every time the Mississippi escapes its banks? In the same way, the marketability of private long-term care insurance is also undercut by the easy availability of nursing-home care financed by Medicaid. One can only wonder at the possible effect on private life insurance sales of the government's liberal indemnification of families victimized by the World Trade Center attacks.
Thus, government impedes the effectiveness of private insurance in two main ways: first, by trying to improve on private insurance with arbitrary controls; secondly, by allegedly mitigating the risks against which private insurance should protect us through mandatory social insurance, public welfare, and emergency grants and loans.
Insurance and Morality
We have seen that insurance performs a vital economic function. To the extent that government regulates or subsidizes insurance, it also becomes a political issue. But insurance has a moral
dimension as well. Insuring against risk is one of the most important ways in which individuals take full responsibility for their lives, in accordance with the ethics of Objectivism
. And the private marketplace for insurance illustrates how trade allows individuals to cooperate for mutual benefit.
- Insurance is individualistic. Individuals buy insurance by voluntary choice to protect their own self-interest (including the interests of their loved ones and dependents) in accordance with their own assessment of their individual needs and circumstances.
- Insurance is rational and objective. It helps us prepare for the unexpected based on facts and analysis, so we don't have to depend on wishful thinking or blind hope. Premiums and benefits are based on objective risks as determined by hard actuarial data.
- Insurance depends on the trader principle. You won't buy it and the insurance carrier will not sell it unless you each perceive that the transaction will leave you both better off than you were before. When this simple principle is allowed to operate in a free market, the result is a profusion of different policies—covering a wide range of risks, benefit levels, terms and conditions, and durations—that an individual can tailor to his unique situation, with prices controlled by competition.
- Insurance is fair. You know you get what you pay for because your premium is based on underwriting, which measures and prices the level of risk you bring to the risk pool. Nobody forces you to buy insurance, but if you don't have it, you are responsible for the punishing financial consequences if and when the insurable event occurs.
- Insurance serves life. It helps us to manage uncertainty and therefore preserves, sustains, and promotes life.
By contrast, social insurance violates those same ethical principles.
- Social insurance is collectivistic. It treats individuals as means to an end by sacrificing their interests for the sake of others.
- Social insurance is subjective. "Premiums" and benefits are based on political considerations and are established by the authorities.
- Social insurance is non-rational. You pay what it charges and get what it gives you without regard to any reasoned calculation of what you want, what you need, or what you can afford.
- Social insurance is inequitable. By treating everyone the same, it punishes some people (the most responsible and least risky) to reward others (the least responsible and most risky).
- Social insurance violates the trader principle. It is compulsory and monopolistic. It prevents people from choosing to opt out; it offers a single policy with few options, if any; and it is not subject to competition.
- Lastly, social insurance undermines life. It creates a false sense of security that anesthetizes people to risks that they must recognize and confront to live safely.
For all these reasons, it should be clear that "social insurance" is not a type of insurance but its antithesis. It is not a means of dealing with the chaos and confusion of life; it is a source of chaos and confusion. Because social insurance rests on the politics of demagogy, it renders future freedoms and obligations unknowable, and so vitiates our ability to plan. Because social insurance operates through taxes, it robs us of our money—the principal tool we need to give substance to our plans.
The question, then, is not whether social insurance should become private. That is like asking whether drunk drivers should become sober drivers. Of course they should. And social insurance thus needs to be fought through a well-grounded moral crusade, carried to the voting public through lectures, articles, and other means. But until politicians show an inclination to give up their demagogic joy rides, the uncertainties generated by social insurance will remain a personal threat, compounding the uncertainties that are inherent in life. Although we cannot entirely escape the cost of government intervention, we can gain a measure of independence by refusing to rely on government's offer to help. We can and should use genuine insurance—private insurance—to build a wall of private protection between ourselves and life's uncertainty that depends as little as possible on government promises and programs.
This article first appeared in the November/December 2002 issue of Navigator magazine.
Stephen Moses is President of the Center for Long-Term Care Reform. The Center promotes universal access to top-quality long-term care by encouraging private financing and discouraging welfare financing of long-term care for most Americans. As President, Mr. Moses publishes and speaks throughout the United States on public versus private financing of long-term care and related issues. Previously, he was Director of Research for LTC, Inc., a Medicaid state representative for the Health Care Financing Administration and a senior analyst for the Inspector General of the U.S. Department of Health and Human Services. Read Steve's full professional bio.