Of all the health care buffoonery we’ve witnessed since the Affordable Care Act (ACA, or Obamacare) was first introduced in Congress in 2009, one of the most egregious is the strengthening of the notion that health insurance should cover a variety of wholly predictable, and strictly speaking, non-insurable events. Charlie Martin recently posted some interesting comments on insurance and why it works, and why public perceptions and public policy are often at odds with good insurance practices. He says that “Insurance Is Always Just Gambling“. True, real insurance is like any other rational hedge against risk, and that can be called a gamble. Unfortunately, public policy often interferes with our ability to hedge these risks efficiently.

Hedged Risk Or Prepaid Expenses?

To begin with, insurance is a mechanism for individuals to manage the financial impact of events that are unpredictable and potentially costly. These are insurable risks. But if an event recurs regularly, like an annual physical exam, a breast exam, or a pap smear, or if an event is largely within the individual’s control, like whether an ugly mole should be removed, then it is not an insurable risk. Paying for such “coverage” through a third-party insurer amounts to prepaying for services for which you’d otherwise pay directly when the time comes. We’ve essentially adopted this prepayment scheme on a national scale through Obamacare’s mandated benefits: we get broad coverage of non-insurable events in exchange for premiums and/or deductibles high enough to cover the prepayments! Big win, huh?

The rationale for a broad coverage mandate is that it will induce healthy behaviors like, well… getting an annual checkup. Therefore, it is said to be in the interests of insurers to include such benefits in basic coverage. That might well be, but the insurers don’t do it for free! Indeed, a combination of premiums and deductibles are correspondingly higher as a result, and the mandate introduces a “middle man”, the insurer, who adds cost to the process of executing a relatively simple transaction.

Unlike these prepaid health care expenses, real insurance is really a sort of gamble. An insurer makes a bet that you won’t have a major, unanticipated health care need, and you put up the “premium” as your bet that you will have such a need. If you are healthy, then the odds are low, so it’s a fairly cheap bet for you, but you have to put up a little extra to pay for your insurer’s administrative costs. Down the road, if you need acute care, your bet pays off. Yippee! You’ll be covered.

But who knows the odds that you’ll need expensive care? And why would an insurer take the risk of losing big if you get sick?

The insurer can estimate those odds via actuarial data and experience, and they can assume your risk by playing the law of large numbers: if they make similar bets with many individuals, their actual losses will be more than covered by premium revenue (most of the time… as Martin explains, it’s possible for an insurer to make a bet with a so-called reinsurer as a hedge against the small risk of a huge loss on its book of business, beyond some threshold).

Shared Risk Or Shared Cost?

Martin objects to the use of the term “shared risk” in this context. Many individuals make similar bets, which makes the insurer’s aggregate payout more predictable. That allows them to offer such bets on reasonable monetary terms, and they are all voluntary contracts sought out by people facing risks of the same character. If an individual seeks to insure against a demonstrably heightened risk, an insurer might or might not agree to the “bet” voluntarily, but if it does, the risk is not truly “shared” by individuals who face lower risks. The high-risk bet is reasonable for the insurer only to the extent that: (1) the premium is actuarially fair in conjunction with a larger pool of high-risk bets, or (2) it can be cross-subsidized by more profitable lines of coverage. If the answer is (2), then premiums for healthy individuals must rise to cover risks they do not share. That is one basis under which Obamacare operates and it is a subtle aspect of Martin’s argument against the notion of “shared risks”. Perhaps we can avoid the semantic difficulty by speaking of “sharing the costs of risks that are not shared”.

A more obvious aspect of Martin’s objection to “shared risk” relates to the expectation that predictable medical costs must be “covered” by health insurance, as discussed above. If so, no risk is shared because there is no risk! Yet we often speak of health insurance “needs” as if they combine a variety of such things, and as if all those “needs” embody risks that are shared. They are not.

Sharing the Cost of Prenatal Care

In another post, Martin tackles the question of whether certain people should be expected to pay a premium that includes the cost of prenatal care. Martin was prompted by a tweet from the National Association for the Repeal of Abortion Laws (NARAL), which read:

“WOW. The #GOP’s reason to object to insurance covering prenatal care? ‘Why should men pay for it?’ #Trumpcare #ProtectOurCare”

There was a link in the tweet to a video, which was captioned by NARAL as follows:

“The GOP reasoning to object to prenatal insurance
Two male Republicans object to prenatal care coverage under the ACA because—while it ensures women have healthy pregnancies—it means men pay *a tiny bit more* for insurance. WOW.”

To the extent that pregnancy can be considered a risk, it is certainly not shared by seniors, gays and lesbians, and infertile individuals, let alone unattached males. And from an insurance perspective, an obvious difficulty with NARAL’s point is that many pregnancies are planned. As such, they are not insurable events (though complications of pregnancy clearly are insurable). Yet people speak as though others must “share” the costs. That is fundamentally unfair and economically inefficient. Subsidies for couples who might wish to have children lead to greater rates of fertility than those couples can otherwise afford, saddling society with the medical bill. Incentives are no joke.

There are also unplanned pregnancies among singles and married couples, however. That sounds more like an insurable event, but it’s usually impossible for a third party to determine whether a pregnancy is planned or unplanned, so moral hazard is an issue (except in extreme circumstances like rape or incest). The risk of pregnancy is confined to a subset of the population, so sharing these costs more broadly is inefficient to the extent that it subsidizes some pregnancies (oops!) that individuals cannot otherwise afford. Individuals and couples who face pregnancy risk must manage that risk in any way they chose, and they might wish to purchase a form of coverage that will help them smooth the cost of pregnancies over their fertile years. It’s not clear that coverage of that nature is better for the prospective parent(s) than a line of credit, but it is a form of insurance only because of the “unplanned” component, and at least it allows them to spread the cost ex ante as well as ex post.

Sharing Costs of Common Risks 

The basic point here is that sharing a risk across all individuals, whether they do or do not actually face the risk, is not a natural characteristic of private insurance. In fact, the idea that this cost should be shared broadly is a collectivist notion. The major flaws are that 1) individuals and couples at risk are not financially responsible for certain cost-causing decisions they might make; and 2) it forces individuals and couples not at risk to pay for others’ risks, which is an act of coercion. NARAL feels that individuals who subscribe to these sound principles are worthy of rebuke. And NARAL asserts that “men pay a tiny bit more“, without providing quantification. Of course, it’s not just men, but this is a variation on the old statist argument that diffuse costs are not meaningful and should be disregarded, ad infinitum.

Public Aid Dressed As Insurance

There are segments of society that are often depicted as incapable of managing risks like pregnancy and unable to afford the consequences of mistakes. Subsidizing those individuals is a second collectivist front for “risk sharing”. Those subsidies can and do take the form of “family planning”, as well as prenatal care and childbirth. That’s part of the social safety net, and while it is perhaps more tolerable as aid, it entails the same kinds of bad incentives as discussed earlier.

The welfare state has seldom been praised for its impact on incentives. Most studies have found a link between public aid and higher fertility, and mixed effects on the dissolution of marriage (see here and here, and for international evidence, see here). But aid for health care expenses should not interfere with the sound operation of the insurance market. Vouchers for catastrophic coverage would be far preferable, and that aid could even cover some regularly recurring health care costs, despite their non-insurable nature, but that would be a compromise.

The misgivings voiced by Martin are partly driven by two fundamental issues: guaranteed issue and community rating. The former means that an insurer must take your bet regardless of the risks you present; the latter means that the insurer cannot charge premiums commensurate with the risk inherent in the various bets it takes. As David Henderson writes, both underpin the ACA. In other words, the ACA imposes cost sharing. Here is Henderson:

“As I wrote over 20 years ago, the combination of guaranteed issue and community rating, a key feature of Obamacare, leads to the destruction of insurance markets. No one would advocate forcing insurance companies to issue house insurance policies to people whose houses are burning, at premiums equal to those paid by others whose houses aren’t burning. And the twin requirements would cause more and more people to refrain from buying insurance until their houses are on fire. Insurance companies, knowing this, would charge astronomically high premiums.“