A while back I wrote about pooling in regards to insurance and how it is theft. I was asked by a colleague if all insurance pooling is theft. The answer is no.
Insurance is something you don’t plan to use which is why health insurance, as most people view it and use it, isn’t insurance at all. It is instead what is called cost shifting, whereby you are consuming at a lower price, more than you otherwise would given accurate market prices, while the rest of the price is picked up by others. What makes this palatable, at the very least, is that presumably the costs are borne by many and the extra cost incurred is small.
This is truly a sucker’s game, one that has driven up health care expenditures while simultaneously driving down out-of-pocket contributions.
Or, as Homer Simpson says, “DOH!!”
So, is health insurance, or any insurance for that matter, a sucker’s game? Hardly. The problem is that pooling is done mostly through force which is why the market distortions occur. And it is a very profitable venture for two of the three parties involved: the insurers (and is it ever profitable) and the over-consumer. The third, who is forced into the system, who under-consumes, is the victim in every sense of the word.
Pooling done through choice however is not only valuable, but vital, for a free economy.
Any venture comes with a risk, even as mundane a task as driving to the store for groceries. Economists know that the greater the risk, the less the chance of the action. While this is similar to the concept of opportunity cost, it differs only in that the negative outcome or loss, is not certain. Buying a $50 pair of shoes necessarily means that one forgoes a $50 pair of pants, with the same $50. (For those who write for the NY Times, this is sometimes referred to as a basic principle of economics, which Austrians believe hold always. For instance, “depression era economics” still means that scarcity exists.)
However, buying a pair of shoes comes with the risk that usage will cause painful blisters. In other words, the cost would be actually higher than just the pants. It would be pain and discomfort as well. Of course, some women will consider that the price of fashion!! Some stores have fairly liberal return policies regarding shoes and lest anyone think otherwise, that policy comes with a cost and it is figured into price of every pair of shoes. It’s true. But, it is why people prefer to buy shoes from a store with such a return policy.
So, assume one buys a pair of shoes from a store with a liberal return policy, and the shoes do not cause them pain. They still paid the premium for the return policy but they did not get back their money spent on such. What they actually bought was peace of mind, thus they remain equally satisfied.
As we can see, risk is a part of every transaction and the riskier the venture, the greater the risk premium. For instance, let’s take a simple example.
Person A in January has a 50/50 chance of incurring a $5000 expense in July. So, Person B says to A, “for a $1000 premium in January, I’ll pick up the $5000 bill in July.” Person A is faced with a decision: forgo $1000 in January and all that could be purchased, never to see it again, or keep it and hope that he gets lucky in July.
Many factors are involved here, and as Austrians know, money, like any other good, has diminishing marginal utility. So, much would be dependent upon the use of the $1000. If for instance, A needed to fix their car as their job was traveling salesman, it might be worth the risk as losing the job would be far more damaging. The point is that one has to weigh the risks of present and future values.
That’s actually a pretty good bet, one most would take. If the numbers were for instance, $1000 premium to protect against a $1500 July bill, most would probably decline. Thus, a July bill somewhere between $5000 and $1500 would be the tipping point, though I’ve no idea exactly what that number would be. This would be, could only be, determined in the market.
This is why it is vital for free economies to work that there be a free (as in truly free market, not forced consumers and over regulated and burdened insurers) functioning insurance market. Entrepreneurs take risks, some greater than others. People invest their capital in wealth creating activities with hopes of future reward. If borrowing the money, they will have to pay a risk premium, usually in terms of a higher rate of interest. And when the market sets that risk premium, that rate or interest and desired rate of return, then the risk/reward model is the great engine of economic growth.
It is the single reason why the most prosperous economies are ALWAYS the freest.
(Note: it might have written that the freest economies are the most prosperous, but this syntax is erroneous. Austrian theory is grounded in the causal-realist approach, that there is cause and effect. By this, I mean that if “free economies are prosperous” is synonymous with “prosperous economies are free” than I am denying that one causes the other. This is false. Economic freedom creates wealth and prosperity. Prosperity doesn’t ever “just happen” nor would it be possible for prosperity to create freedom. It is in considering it in that manner, prosperity creating freedom, where it becomes clear. Thus, freedom is the required antecedent, and thus a casual relationship.)
There is another side to insurance, ameliorating unintended loss. This is a perfect case for actual health insurance. Oddly enough, there is a large and dynamic market for term life insurance, the most extreme example of loss. This is exactly what the health care insurance market should very closely resemble as they are remarkably similar. Quite simply, no one hopes to use their term life insurance, and I imagine, no one truly ever does!! Let’s face it, the one(s) actually using the term life insurance isn’t going to be the person whose name is on the policy.
Although the one with their name on a health insurance policy would be using it, likewise, it would be something they would hope never to use. A perfect example is catastrophic insurance such that s one were to be afflicted with a severe illness, instead of a million dollar hospital bill, one might only incur say a $10,000 bill. You don’t ever plan on accruing a million dollar hospital stay, so any premiums paid towards such would be completely to avoid that risk. And nothing else, period.
Returning to pooling, the original example is poor only in that no insurer would underwrite such a policy. Here’s why: for every two people that pay into the plan, one is going to receive a $5000 payoff, or $2500 per person insured, while the premiums collected would be $1000 per person. In other words, while collecting $2000, they are paying out $5000. (for quick reference, that’s sort of how social security will work in a few years!) What they need to do is collect more than $2500 per person. Thus, for this example to work, the premiums would need be at the least, $2501.
This system works wonderfully as long as like risks are pooled together voluntarily. Thus risks, premiums, and payouts truly and accurately reflect consumer desires. Car insurance works in the fashion.
Using a simple numerical example will help. For many drivers, the chance of a $100,000 liability in an accident is remote, say 1 in 1000. Thus, all that is needed would be 1001 drivers to purchase a $100 policy, as 100,000/1000 = $1000 per driver payout. (Yes, the additional driver adds a fraction to the per driver payout, but for this example, it is insignificant.) It works wonderfully as a $100 premium is a pittance compared to a potential $100,000 bill.
Insurance companies do quite well because they charge in excess of $100 per person. And they do this not because they are greedy and evil, but because the risk protection is worth far more than $100 to each driver. In fact, it is probably worth several times that. So, instead of collecting $101,000, they charge say $250 per driver for such a policy, and end up collecting $250,000 total. If that’s sufficient to lure others into the car insurance business (again, assuming a free market, no regulatory rent seeking firms blocking such), great. More competition, better services, and lower prices. If not, great. Consumers are still purchasing exactly what they want at the market price.
And as such, voluntary pooling of similar risks represents a vital and extremely valuable tool for risk management. It is not theft in any way, shape, or form. But forced pooling of disimilar risks most certainly is.