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Posts Tagged ‘Risk’

At Cafe Hayek, a reader asked Russ Roberts how the elderly would be able to purchase health insurance on a free market, one without Medicare or Medicaid.

Tom’s question is interesting. But it’s the wrong question. And that Tom asks it and that everyone answered it is fascinating in and of itself.

It’s the wrong question because when you’re 65 the problem isn’t getting insurance. It’s paying for health care. But the public debate has become so obsessed with health care insurance we’ve forgotten what the real issues are.

When you turn 65, the high cost of insurance isn’t the problem. The problem is that you’re old. A lot more things are going to go wrong. Yes insurance is going to be costly. But that’s because so many things are more likely to break in your body. The high cost of insurance at that point is just a result of the problem. It’s not the problem itself.

It’s like saying that if you drive your car in a demolition derby, it’s hard to get coverage for collision damage. No kidding.

What’s funny (well not funny, really) is that we’ve totally forgotten the point of insurance and why it’s economically sensible. Insurance is designed for the unpredicatable. There’s nothing unpredictable about bad health when you get old.

Read the whole post.  This explanation is quite consistent with my observation that many people discussing health care policy today ignore or do not understand what the purpose of insurance is.

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Something that has puzzled me  about the debate on health care reform is the framing of insurance companies as organizations that fund health care for their customers.  Advocates of the public option offer the idea that the government will be better able to to provide health care, as against the insurance companies, which have failed to do provide enough care, for whatever reasons, such as high prices, patient dumping, et cetera.

Insurance companies aren’t supposed to fund care as an end in itself.  They provide care to hold up their end of their contractual obligations, because they buy risk from customers.  They only provide care in so much as they need to reimburse customers for unforeseen medical costs.

Generally, consumers reveal preferences that show that they are risk averse.  There are exceptions of course; people get utility from gambling, and suffer from the pseudocertainty effect.  Generally though, purchasers of insurance make a calculation in their head that they would rather pay about a hundred dollars each month than worry about paying tens or even hundreds of thousands of dollars for a treatment at some unknown point in the future.

Trade is positive-sum.  On one side of this trade, consumers sell their risk.  So, what do the insurance companies get?  Insurance companies can calculate risk for each contract and distribute that risk throughout their pool of customers.  They know that they don’t have to provide a payout for those customers who don’t get sick, but because they’ve taken money from all their customers, they can afford to fund those people who do get sick and are entitled to expensive treatments.  This is how they turn a profit.

This is just a basic description of what an insurance market is.  It applies to other kinds of insurance, not just health insurance.  There are certainly instances of injustice where insurance companies deny care inappropriately, and there are other interesting features of insurance markets that I haven’t mentioned.  My purpose is just to correct the strange assumption that the purpose of health insurance is to fund care, because it is not.  Insurance companies buy risk and manage it.

We should be especially skeptical of any public plan that the insurance companies support, because in the political realm, those companies have the opportunity to manipulate the system in their own favor, at the expense of everyone else.

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