Insurance and Economic Illiteracy

Much of this will likely come as no surprise to the readers of this blog, whom I suspect are supporters of the free market. However, much of it also goes unsaid as assumed premises; so I sought to write something down.

Imagine for a moment you have just bought a car. You go to get insurance and your lienholder (because you took out a 0% APR loan) puts restrictions on your insurance plan to the point that there’s only 1 plan available for you to get. You sign up for it, and drive away. (This is a thought experiment, so assume there’s no kickbacks or anything, just one plan that meets the requirements.)

A few days later, you’re looking at the paperwork and you notice something at the end that peaks your interest. As part of the “generous ancillary benefits” this plan includes reimbursement up to $40 for oil changes 6 times a year. The only requirement is that you use a mechanic licensed to perform state inspects, and you submit an itemized receipt with his state inspection license number. There’s a mechanic up the road you’ve been using, you ask him if he can do that and he says “yeah, I’ve got bills right here with my number right on the letterhead, I’ll just put your receipt on that.”

Now assuming there’s no negative impact to your car, what incentive do you have not to get an oil change every 2 months and spring for the expensive oil? Aside for your time, I can basically see none. (Assume time to complete the submission is negligible.) Indeed, because you have already effectively paid for these oil changes (via your premiums) it’s in your best interest to get as many as allowed.

Now we’d raise our eyebrows at such a car insurance plan, and increasingly this is direction that health insurance is moving. Dig deep enough in any policy and you’ll probably find some directly useful benefit. I dug deep enough and found that my insurance covers massages up to $60 some forty times per year. A friend found that hers will reimburse her for the gym membership up to $40/month. What incentive do we have not to use these benefits, after all we’ve paid for them? (Mine also covers acupuncture and chiropractors the same way, the incentive not to use that is I’m not an idiot who wants voodoo needles or voodoo back popping.)

Which brings us to the point about illiteracy. Sometime back, I was finishing formatting some guidance for my IRB. While doing this I was listening to the Freakonomics podcast. Steve Levitt made a point about insurance that was interesting and (IMHO) ultimately wrong:

I have the absolute minimum insurance. I think insurance is greatly, the value of insurance is greatly exaggerated in almost all cases. Many people, I think, don’t understand the purpose of insurance. The purpose of insurance to an economist is to shift money to what we call states of the world, in which money has a lot of value relative to other states of the world. Okay, let me try to say that. That was like econ-speak…

DUBNER: Yeah, that was… that was good though.

LEVITT: Okay, so before your house burns down, if you have a dollar it’s not worth as much to you as after your house burns down. So if you could magically find a way to trade a dollar before your house burns down for a dollar after your house burns down, you’d want to put more money in the after the house burns down category—this is a world of no insurance—so that you could buy all the stuff that got burned down in your house, ok? And that is the purpose of insurance. It’s a way of moving around money so that you have it when you need it, not when you don’t need it. [Emphasis added]

Now think about that for a second, Levitt, a world renowned economist is basically say that insurance is a way to passing money forward to a time when you need it. But that’s wrong. Insurance (by and large) is about pooling risk so that I don’t have to hedge against expensive, and highly unlikely events. The chance that my has a fire over a five year period is a little under 1:300. Stats was never my strongest subject, but It’s probably fair to say that over a 60 year period you’re looking at less than a 5% chance of a house fire (and an even lower chance of a catastrophic home total loss fire.) Thus setting aside enough money to hedge for this catastrophe is somewhat impractical. Instead, I pool risk with thousands of other homeowners, so instead of setting aside 250k, I set aside roughly $1500/year, which over a 60 year period is 90k, far less than the total value of my house. (Yes, I know my premiums will increase, this is back of the napkin math.)

Now, I said that insurance is “by and large” about pooling risk. There is some element of what Levitt is talking about in insurance. My insurance most likely prices in that over a 10 year period many (not all) people in St. Louis will need a substaintial roof repair or replacement due to the common nature of hail (and other severe) storms here. But I think it’s fair to say that this is not the primary driver of home insurance.

However, this type of dollar shifting is all but becoming the primary driver of health insurance. Consider for example Obamacare’s 90% rule which defines insurance in terms of total dollars spent on care directly. In the short term what you see is a shifting of money from the relatively healthy to the sick. Over the longer arc of life you’d see a shift from younger healthy years to older sicker years. (Plus a some more of that “healthy to sick” shifting but over an entire lifetime it’d be less pronounced).

As well you’re seeing more and more “benefits” being crammed into insurance. Everything from annual physicals to birth control. The reason given is saving money but there are more than a few reasons to be suspect of the math on those. (The articles touting birth control’s money saving magic always make stupid assumptions about who pays for birth control. Does 100% birth control coverage save insurers money? Well that depends on the risk of unplanned pregnancies in your insurance pool. Even before Obamacare’s magic money shifting, higher education tended to result in a lower unplanned pregnancy rate. Meaning in these populations 100% coverage is probably a net loser for the insurers since their pool would use birth control without coverage.)

Additionally, Obamacare contains clauses which basically legitimatizes the alternative medicine movement rendering it equal to real medicine in many respects. My oil change analogy actually falls short here I suppose, because this more like spraying your engine with some water, charging $40 for “oil improvement” and still doing the oil changes every 2 months.

Now Obama didn’t create this problem. Arguably it goes back to FDR’s wage controls and the rise of insurance as a form of compensation. Health insurance specifically seems prone to this distortion. (When was the last time you heard someone brag about their job’s life insurance benefit?) And Obama certainly doubled down on it. The question is: can we fix it. Sadly I think the answer is most likely “no.” The idea that insurance is basically a savings account (rather than risk pooling) is already ingrained in the American mindset. Look at Liberty Mutual’s latest ad runs to see how the idea is spreading. Something catastrophic (the collapse of the entire healthcare system for example) might trigger a reset. But by then it’s already too late.