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November 1996
Volume 14, Number 11

The Insurance Scam
Michael Levin

The Senator has a painful announcement to make. His daughter is mentally ill. This gives him special insight into a social injustice: insurance companies are less willing to cover mental illness than other forms. They place annual and lifetime limits on the number of permitted psychiatric sessions, for example.

Moved by his pleas, the entire Senate agrees to stamp out bias against mental illness with a new law. If firms offer mental coverage, the law says, it must be identical to other forms of coverage. Otherwise, the victims of mental illness will continue to be "stigmatized."

It's no shock that the Senate has taken another step towards socializing the medical sector. That's been the pattern for nearly a century. What's appalling is that this socialization is confused with authentic insurance, a viable market institution.

Here's how real insurance comes about.

Life is risky. The roof might fall in. You might get hit by a car. Your own body might rebel, sending cancer cells on their deadly metastatic journey.

In theory, an individual can manage risk by himself by exercising extreme caution. He may stay home permanently while paying someone to run errands, or set foot outside only after exhaustive research on weather and traffic.

The trouble with most individualistic measures, though, is that they are self-defeating--sitting in one's living room all day (under a reinforced roof) is hardly conducive to good health--or prohibitively expensive. Worse, the individual is lost if his private preventive measures fail.

A better hedge is a risk pool, a group of individuals agreeing to help each other in case disaster strikes one of their number. Risk pools are common in everyday life, where high school students take notes for friends who miss class, and office workers share computers should one crash.

One obvious benefit of pooling risk is cost: letting someone use your computer should his break down, in exchange for use of his in case yours does, is cheaper than buying a backup system. A greater benefit of risk pools is their access to resources to offset the aftermath of disaster. If, despite every self-reliant effort at safety, your house catches fire, you are minus a house. Join a voluntary fire brigade, and your house may be saved.

But risk-pooling has its downside. There is of course each member's contribution, the premium he must pay. It is a nuisance to take exhaustive notes in chemistry class whenever a friend is absent. There are the transaction costs of calculating the resources each member must put in to balance expected gains. In fact, even though on average everyone gets out exactly what he puts in, the careful or lucky risk-pooler will put less into the bargain than he gets out.

Enter the entrepreneur, offering to assume everyone's risk for a price. He sells you coverage should some evil befall at a cost exceeding your expected gain; after all, the insurer is not in it for his health. (He's in it for yours.) In exchange, you save on negotiating time, and, more important, you gain surer protection against a wider range of catastrophes.

Spontaneous risk pools tend to be small, and limited in purpose. The guys in the office will cover for you if you miss a meeting, but they cannot put your kids through college if you die.

However, suppose an entrepreneur finds 100,000 people, each willing to pay $100 for the assurance that his kids will be put through college should he keel over in the next ten years. The pool now contains $10 million, enough for plenty of tuition bills. Enterprising insurers can merge payments to cover unique risks: Lloyd's once insured Marlene Dietrich's legs.

The critical factor controlling an insurer's costs, hence the price he asks for a policy, is the probability of disaster. He can sell life insurance of $50,000 to 100,000 people at $100 a head only if it is actuarially certain that fewer than 200 subscribers will die in the next 10 years. He will go bankrupt should he underestimate the risk, leaving his remaining subscribers exposed once again.

So it is in the interest of the subscribers and the insurer that insurers protect only those unlikely to sicken, die, or get into auto accidents, and charge more as the likelihood of these mischances rises.

Consequently, it is in the interest of both insurer and subscriber that insurers use all available information about potential clients to maximize the accuracy of probability estimates. Should family history be relevant to expected life span, for instance, Smith's insurer (seconded by other subscribers) will want to know his father's age at death.

Should ignoring this factor underestimate risk, Smith's premiums will be too low. The insurer has made a potentially expensive mistake. If the insurer makes too many mistakes, it will be outcompeted by insurers who are better at assessing potential risk.

Should ignoring this factor overestimate risk, Smith should take his business elsewhere. If an insurer does this often, it will lose business to other insurers. This pull and tug of the competitive insurance marketplace pushes risk and premiums to a proper level, so both insurers and those they cover benefit from exchange.

Commercial insurance plans are as voluntary as informal risk pools. Nobody makes anyone take out a policy. For the same reason, the nosy questions asked by an insurance company do not invade your privacy. You may decline to reveal your blood pressure, or whether you are HIV-positive--just as the insurance salesman may decline to sell you a policy.

This is why government regulation of insurance, and the excuses for it, are nonsensical. The New York State legislature passed a bill requiring insurers to pay for chiropractic services. "Genetic discrimination," i.e. the use by health insurance companies of the results of genetic tests, is illegal in New Jersey.

Connecticut is considering a law that would forbid health insurance companies from refusing to insure women who have survived for five years after breast cancer. Many other states forbid health insurers to turn anyone down on the basis of HIV-positivity. In a sweeping approach, a new federal law bars insurers from denying coverage to people on the basis of "pre-existing conditions."

In the Alice-in-Wonderland rhetoric of socialism, such regulation is "a freedom-of-choice-in-health issue" (the New York Chiropractic Counsel) that "protects against genetic discrimination" (a New Jersey State Senator), fends off "discrimination against people predisposed to breast cancer" (the National Breast Cancer Coalition), and gets "rid of the terrible stigma and discrimination based on mystique, mystery, and Dark Age concepts" (Senator Pete Domenici). As one advocate of insurance regulation sums up: "Genetics should not be used against people."

But people can't be protected from "genetic discrimination," and genetic information cannot be "used against" anyone, because the practices so tendentiously described do no harm. You do harm only by making someone worse off, and an insurance company refusing to cover a man genetically disposed to cancer or mental illness, or offering coverage at an unusually high rate, leaves him no worse off. He was uninsured before, and uninsured now.

Buying a policy at a higher rate betters his condition, for he clearly prefers the cost-with-coverage package to previous vulnerability. If the rate is too high, he can choose not to pay the necessary premiums and hope that his total out-of-pocket costs never add up to more than the total premiums.

Should insurers be forced to sell him a policy in ignorance of his genetic make-up--a proxy for his likelihood of getting sick--other policyholders will be forced to support his family if he does contract terminal cancer. That tramples their right to free association. This right includes association for risk-sharing, under any terms the associates please. There is no more right to insurance than there is to someone else's notes for your 8:00am chemistry class if you are a genetic "night person."

When insurance companies and healthy policyholders are considered at all, the issue is usually put as one of "balancing" their interests against the "freedom" to have insurance. Yet not only is the freedom of insurance companies to deal with whom they please also at issue, this freedom is the more fundamental of the two.

In a market system, the Senator and his unfortunate daughter have two choices: pay for treatment out-of-pocket, or pay the premiums necessary for the unlimited medical attention she desires. A remedy that involves government coercion is not insurance but welfare.

Freedom to share risk limits no-one else's freedom to make similar arrangements. Freedom to have protection at a fixed cost necessarily excludes others from that same good. Contrary to the endless propaganda of the welfare state, the desirability of insurance coverage creates no right to it.

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Michael Levin teaches Philosophy at City College of New York

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