Uncertainty and Its Exigencies: The Critical Role of Insurance in the Free Market
Any insurance involves the pooling of individual risks. Under this arrangement, there are winners and losers. Some of the insured will receive more than they paid in premiums and some will pay more into the system than they ever get back. This is a form of income redistribution from the healthy to the sick, but the characteristic mark of insurance is that no one knows in advance who the winners and losers will be. They are distributed randomly or unpredictably, and the resulting income redistribution within a pool of insured people is unsystematic.
If this were not the case — if it were possible to predict the net winners and losers — the insurance losers would not want to pool their risk with the insurance winners; they would seek to pool their risk with other "losers" at lower premiums.
For example, let's say my insurance provider wanted to pool the injury risk of someone like me, who sits behind a desk all day, with the risk of a professional football player. In that case, we can easily predict that I will end up being a constant loser: hardly anything happens to me, but plenty of accidents will happen to the professional football player, and my premiums would have to cover his significantly higher risk of injury.
Now even if the insured themselves do not recognize that there are systematically predictable winners and losers, free competition in the insurance market would eliminate all systematic redistribution among the insured.1 In a free market, any insurance company that engaged in any systematic income redistribution (mixing people with objectively different types of risks into one single group) would be outcompeted by any company that did not engage in this type of practice. Another insurance company might realize that there are people who sit behind desks and rarely fall off their chair and injure themselves. They would recognize that they could profitably offer a lower premium to desk jockeys and insure them in a separate pool from the professional athletes. And by offering lower premiums, they would of course lure away those people who had previously been misinsured. As a result, the various companies that had misgrouped people (by mixing their low-risk clients in the same pool with their high-risk clients) would have to raise the premiums for their higher-risk clients to their naturally higher level.
Competition in the insurance market would lead to ever more-refined subgroupings of people into groups that are internally homogeneous. The discrimination of groups and subgroups would occur according to actual group risks and the premiums for all groups would then reflect the genuine insurance risks for that group, and prices on the average would tend to fall due to competition.
To put an individual client into the right group, the insurer has to discriminate according to various criteria. In the case of flood, hurricane, earthquake, or fire insurance, they would use regional or geographical criteria. They might use biological or genetic characteristics in the case of health insurance. They might use certain behavioral criteria or lifestyles: smokers and non-smokers, people who are occupied in certain occupations that cause greater or smaller risks, and so forth.
The Limitations of Insurability
Are there certain risks against which we simply cannot insure ourselves? Mises defines events that can be insured against as "risky events" and he uses a definition of what he calls "class probability" to define these risky events:
We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.2
And then he gives some examples. For instance:
We have a complete table of mortality for a definite period of the past in a definite area. If we assume that with regard to mortality no changes will occur, we may say that we know everything about the mortality of the whole population in question. But with regard to the life expectancy of the individuals we do not know anything but that they are members of this class of people.
Let us assume that ten tickets, each bearing the name of a different man, are put into a box. One ticket will be drawn, and the man whose name it bears will be liable to pay 100 dollars. Then an insurer can promise to the loser full indemnification if he is in a position to insure each of the ten for a premium of ten dollars. He will collect 100 dollars and will have to pay the same amount to one of the ten. But if he were to insure one only of them at a rate fixed by the calculus, he would embark not upon an insurance business, but upon gambling.
And then he says, concluding:
The characteristic mark of insurance is that it deals with the whole class of events. As we pretend to know everything about the behavior of the whole class, there seems to be no specific risk involved in the conduct of the business.
Neither is there any specific risk in the business of the keeper of a gambling bank or in the enterprise of a lottery. From the point of view of the lottery enterprise the outcome is predictable, provided that all tickets have been sold. If some tickets remain unsold, the enterpriser is in the same position with regard to them as every buyer of a ticket is with regard to the tickets he bought.
Now note again that this definition of what he calls "class probability" implies the absence of any systematic redistribution of income: If I know nothing about any particular person's individual risk except that he is the member of some group with a known group risk, then all redistribution must be random. It implies also that the individual cases that are grouped into one risk pool are homogeneous. Within the group, we cannot tell the difference between one individual and another. This implies also that the actual event comes in the form of an accident — and unpredictable event for the individual.
Now by exclusion we can also approach the complementary questions: What sorts of events are uninsurable? When is the pooling of risks impossible?
An uninsurable risk is one where the following condition holds: If I know with regard to a particular risk some or all of the factors that determine its outcome, then such a thing is no longer accidental; its likelihood can be individually affected, and therefore cannot possibly be insured. Or, to formulate it somewhat differently, everything that is within either full or partial control of an individual actor cannot be insured — cannot be risk-pooled — but falls within the realm of personal or individual responsibility.
Every risk that may be influenced by one's actions is therefore uninsurable; only what is not controllable through individual actions is insurable, and only if there are long-run frequency distributions. And it also holds that if something that was initially not controllable becomes controllable then it would lose its insurability status. With respect to the risk of a natural disaster — floods, hurricanes, earthquakes, fires — insurance is obviously possible. These events are out of an individual's control, and I know nothing about my individual risk except whether or not I am a member of a group that is, as a group, exposed to a certain flood or earthquake or fire risk.
In contrast, take for example the risk of committing suicide. Would it be possible to insure oneself (to pool one's risk with others) against suicide? The answer should be quite obvious: such a thing is not a viable venture for an insurance company. After all, I have full control over whether or not I deliberately kill myself. An insurance company that offered suicide insurance would of course attract potential suicide candidates. I could go there because I want to do my wife a big favor, pay the premium, shoot myself dead, and then my wife will be a millionaire. Insurance companies that would insure such a thing would likely disappear from the market very quickly.
Or take another example. Would it be possible to insure oneself against committing arson — that is against the risk that I will burn down my own house? Again, the answer seems to be clear that any event that I can bring about deliberately (or the likelihood of which I can affect) is, strictly speaking, an uninsurable event. The risk that my house will be set on fire by lightening can be insured against; the risk that I set my house on fire is not an insurable event.
Now take the example of unemployment. As you know, there is something called "unemployment insurance." In the modern world we have invented the art of misnaming things, of applying terms that are completely inappropriate and then trying to fool people into believing that by changing the words, we have changed the nature of things.
Unemployment is an uninsurable risk. I have full control over being employed or not being employed. All I have to do is tell my boss what I really think of him and I will soon be unemployed. On the other hand, I can almost always make sure that I will be employed if I am willing to take drastic wage cuts, for instance. If I were to work for free, I would be employed. So obviously this is not a risk that is insurable. It falls into the realm of individual responsibility.
Here is an example that begins to take us in the direction of the health insurance question: the risk of not feeling good in the morning and not getting out of bed. No insurer could ever cover such a "risk," because people do have at least some control over how they feel in the morning. If I were insured against this risk — paid whenever I don't feel so good — you can be pretty sure I would spend far more time in bed than I currently do.
With respect to all these risks then, I cannot say, "I know nothing about the particular risk except that I am a person and all persons are afflicted by these risks with a certain frequency." In fact I know considerably more about my individual risk, just as you know considerably more about your individual risk.
Take an example where we have at least partial control. Can I insure myself against the risk of making business losses? Obviously not. While I have no direct control over the actions of the buyers and non-buyers of my products (those who do directly determine my profits and losses) I do have some control over my business's success or failure. I have control over my production costs, as well as the kind and quality and price of the product I produce. In fact, I can make losses deliberately if I want to. It would be impossible for me to pool my risk with other business people, as if losses were something like being struck by lightening.
Now with this distinction between accidental events, which are insurable, and events that are uninsurable because individual action can affect their likelihood, what then can we say about the possibility of health insurance?
The first thing we can say is that sickness is insurable only insofar as the health risk for a particular group is purely accidental. Such is the case with certain forms of accident insurance, or even for events such as cancer. But for most health risks, we would have to say that they fall into the province of individual control, and very little in this field is actually insurable. Such risks must be assumed individually and must be paid for out of individual savings.
Now in all recent debate about health insurance and healthcare reform, the fact that certain things are completely uninsurable is rarely if ever mentioned. Mises was the exception. In 1922, well before the current healthcare craze, Mises addressed these issues in his book Socialism. Here is a quote that is highly revealing:
To the intellectual champions of social insurance, and to the politicians and statesmen who enacted it, illness and health appeared as two conditions of the human body sharply separated from each other and always recognizable without difficulty or doubt. Any doctor could diagnose the characteristics of "health." "Illness" was a bodily phenomenon which showed itself independently of human will, and was not susceptible to influence by will.
And then he comments on this by saying:
Now every statement in this theory is false. There is no clearly defined frontier between health and illness. Being ill is not a phenomenon independent of conscious will and of psychic forces working in the subconscious. A man's efficiency is not merely the result of his physical condition; it depends largely on his mind and will. Thus the whole idea of being able to separate, by medical examination, the unfit from the fit and from the malingerers, and those able to work from those unable to work, proves to be untenable. Those who believed that accident and health insurance could be based on completely effective means of ascertaining illnesses and injuries and their consequences were very much mistaken. The destructionist aspect of accident and health insurance lies above all in the fact that such institutions promote accidents and illness, hinder recovery, and very often create, or at any rate intensify and lengthen, the functional disorders which follow illness or accident.
Back to the example I gave before: Assume that we could insure ourselves against not feeling well enough to get out of bed in the morning. You can easily see that this would create a class of malingerers and would discourage people from getting up, regardless of what their physical condition might be.
Now in light of all of this, when we look at the question of health insurance, we would expect that most risks would have to be assumed individually. Insurance (the pooling of risks into groups) would have to be limited to the strictly accidental variety of risks, and even there, individuals can fraudulently bring about apparent "accidents," as is quite frequently the case with workers compensation.
And, of course, insurance companies would have to offer strictly limited coverage: There would be no coverage of newly discovered risks, for instance. There also would be no such thing as "cost plus" — where, for example, my house burns down and I can force the insurance company to build me a bigger house. The insurer would only insure the value of the house up to the value I insured. Under the current system, we see cost-plus all the time in the form of Medicare and Medicaid, where whatever the doctors deem necessary is automatically covered.
Generally, insurance would be in the form of indemnity or cash payments. Some insurers might offer in-kind services at specified, restricted providers or providing facilities, but this option would be less attractive to most customers and to most insurance providers as well.
Any further expansion of insurance in health matters, if it takes place at all, would be severely restricted to cases of very small groups of individuals who, as buyers of individual health maintenance services from a specified provider, are extremely homogeneous. We can imagine, for instance, that people would engage in mutual insurance services if their group can exercise extreme social control. To make sure there are no malingerers included, the members of such a group would have to have very similar outlooks on life.
Now if we look at the present reality of health insurance, we recognize immediately that the current situation has very little if anything to do with what we would expect from a free insurance market. What characterizes the present situation is, first of all, that manifestly different risk groups are grouped together in a joint pool. Furthermore, the current healthcare insurance system covers risks that are, strictly speaking, uninsurable.
To a large extent health insurance has become a form of welfare, the machinery of income redistribution. How has this happened? Insurance regulation.
State Regulation of Insurance
Let me give you some examples of the perversions that have been introduced into the insurance market due to state regulations. Insurance companies in the United States are regulated at both the state and federal level. The number of state regulations alone have risen from a total of 8 mandates in 1965 to close to 1,000 in the early 1990s. I have not looked into the numbers more recently, but I'm sure they go up day by day.
- In 49 states, insurance companies are forced to cover treatment against alcoholism, which is obviously something that can be individually affected (or even if we say it cannot be individually effected, we would have to say it does not affect all people in the same way). Nonetheless all insurance companies must offer insurance against alcoholism.
- In 27 states, they must cover treatment against drug addiction. In other words, people who know that they will never use any addictive drugs nonetheless have to pay through their premiums for people who do make use of and are affected by this particular risk.
- The coverage of chiropractors is mandatory in 45 states.
- Podiatrists (foot doctors) in 37 states.
- Psychologists are covered by mandate in 36 of the states. Again, it should be perfectly clear that the desire to go or not to go to a shrink can be individually affected. I know people who go to shrinks all the time. I myself would never ever enter a shrink's office. Nonetheless, through my health insurance premium I have to pay for the risk of a group that is clearly different from my own risk.
- In 22 states, the services of social workers have to be included in the coverage and of course are reflected then in the premium.
- Georgia requires coverage for heart transplants. Now again, heart transplants might certainly be a risk that can be insured against, but it should be perfectly clear that this risk is different for different groups. Some people have a genetic predisposition to heart disease and others don't. You cannot opt out of this type of coverage. You get it whether you are affected by it or not and you have to pay whether you are affected or not.
- In Illinois, liver transplants have to be included. In Minnesota, hairpieces have to be included. Again it should be pretty clear that different families have different risks of hair loss.
- Marriage counseling has to be included in California. Pastoral counseling in Vermont,
- And (very nice) sperm banking in Massachusetts. (If you were to have predicted a state where that had to be covered, Massachusetts would of course have come up pretty soon, I'm sure about that.)
- In more than a dozen states, insurance may not ask any AIDS related questions. And in Washington DC (again a place where you would expect this) any HIV testing is prohibited for all insurers. That is almost the same as if you could burn your house down first and then retroactively insure yourself against it.
- In California (again, a not-so-surprising candidate for these sorts of insanities) there can be no discrimination between any genetic traits that distinguish people. For instance, sickle-cell anemia affects mostly black men. Nobody is allowed to investigate this from the outset. Tay-Sachs disease affects mostly Jews, but that cannot be considered when insuring against the risk of the disease. With the advances we make in genetic research, these types of differentiations would become finer and finer as scientific progress is made, but insurance companies are barred from recognizing this type of progress.
Now all of these mandates are at best a mixed blessing for the insurance companies. On the one hand, as insurance companies have to cover more and more uninsurable risks, they are continually forced to raise premiums. State regulation lets them get away with these higher prices, because competition from more discriminating insurance providers has been disallowed.
But as prices go up, more and more people drop out of the insurance market altogether. They recognize that most of the risks don't apply to them and they make a rational decision between being "overinsured" at extraordinarily high premiums or uninsured. Keep in mind that in the current discussion about all of these things, there is this constant whining about all the people who are uninsured, without of course emphasizing that to a large extent, this is precisely the effect of the previous interventionist policies.
It is increasingly rational for people to be uninsured.
Of course, dropping out of the insurance market is a risky thing to do, but young healthy people are almost crazy to pay the high premiums that come about from subsidizing all these unhealthy lifestyles and covering risk that they know don't apply to them.
This is a lesson in the logic of interventionism.3 The first interventionist act brought about a big mess — insurance premiums always go up because insurers are no longer allowed to discriminate correctly and are even forced to include uninsurable risks. So now the problem arises of more and more people dropping out. For those who remain insured, premiums have to be raised to adjust for the fact that so many are dropping out.
The next step, which we in the United States are on the verge of taking, is to make health insurance compulsory. No More Dropping Out! If this step is taken — compulsory health insurance, with all the other mandates remaining in place — then of course premiums will skyrocket even more than they have in the past.
What then will be the next step? This too can easily be predicted: there must be cost controls imposed. There will be a rebellion on the part of the public, who will say, "The price is out of control! The government has to do something!" But all the government can do is engage in price controls. What happens with price controls? We get tremendous shortages of certain services, as in places like Canada where you can't get certain treatments and there are one- or two-year waits for others.
All healthcare provision will become increasingly politicized: the government will design lists of good diseases for which you do get treatment (such as AIDS, I'm sure) and bad diseases, such as those you get from smoking too much. Those with the bad diseases the government will let die.
Where does all this lead then? Intervention in the insurance market creates an ever-increasing loss of individual responsibility, creates shortsightedness, and creates hazardous risks. Let me give you another quote from Mises, who was extremely farsighted in all of this:
The psychic forces which are active in every living thing, including man, in the form of a will to health and a desire to work, are not independent of social surroundings. Certain circumstances strengthen them; others weaken them. The social environment of an African tribe living by hunting is decidedly calculated to stimulate these forces. The same is true of the quite different environment of the citizens of a capitalist society, based on division of labor and on private property. On the other hand a social order weakens these forces when it promises that if the individual's work is hindered by illness or the effects of a trauma he shall live without work or with little work and suffer no very noticeable reduction in his income. Matters are not so simple as they appear to the naive pathology of the army or prison doctor.
Social insurance has thus made the neurosis of the insured a dangerous public disease. Should the institution be extended and developed the disease will spread. No reform can be of any assistance. We cannot weaken or destroy the will to health without producing illness.
Let me add some final remarks on the high prices we have to pay for healthcare. Insurance regulation is only one reason for this mess. There are also the significant problems of the FDA and the AMA.
To repair the healthcare system, we need to abolish the US Food and Drug Administration (FDA) and all bureaus of public health and safety, which require all pharmaceutical products to be licensed by them before they can be marketed. These institutions delay the production and delivery of drugs, raise the costs of production, and thereby cause unnecessarily high prices as well as the unnecessary death and suffering that result from the fact that effective drugs do not appear on the market until many people have died or suffered for many years.4
In addition to insurance regulation and pharmaceutical licensing, all welfare states have highly restrictive licensing requirements for medical schools, hospitals, and pharmacies, for medical doctors, and other healthcare personnel. That is to say, the supply of doctors, for instance, is systematically restricted. Like all professions, the medical profession has made the attempt to cartelize the industry — to reduce the supply of doctors and thereby raise the price for medical services. The American Medical Association (AMA) has been more successful in this regard than have other professions. They have engaged in what are basically unionizing policies, the cartelizing of their form of labor.
The tool that the AMA used to create and maintain their labor cartel is government licensing of medical schools. As you know, there is a huge demand for people to attend medical school. Why then are there shortages in the provision of medical education? In an unhampered market, the normal response to such shortages would be the creation of new medical schools. So why don't these shortages disappear? Why are there long lines of people who are declined and cannot go to medical school? The answer is, of course, because the opening of new medical schools has been outlawed.
And who is behind this outlawing of new schools? The same people who even attempt to force existing medical schools not to fill all the open slots they have: the currently established medical doctors.5 Now by eliminating all licensing requirements for medical schools and for medical doctors, the supply of healthcare products and services would almost instantly rise and prices would generally fall, and in addition a greater variety of healthcare products would appear on the market.
What about the quality of the new supply of products and practitioners? Competing voluntary accreditation agencies would take the place of the compulsory governmental licensing that exists currently, assuming that healthcare providers believe that such accreditation would enhance their reputations, and healthcare seekers believe it would enhance their safety. Doctors would apply to the most restrictive accreditation board whose standards they believe they could meet. Some would apply to the Harvard Medical Accreditation Board, some to the Tennessee Valley Authority Accreditation Board, or whatever it happens to be. Customers would refer to the accreditation or ratings from the boards they most trust for the doctors they can best afford.
For those who believe that consumer safety would be hurt under such an open, competitive system (a free market in healthcare), let me use an analogy. Suppose you were to say, "Look, some people have crummy Chevy cars, which are less safe and less comfortable. This falls short of our goal that all consumers get only the best. Therefore we should insist that all cars live up to the standards of a BMW or a Mercedes." Would we all wind up with the comfort and safety of driving luxury cars? Of course not. Many of us would have to resort to bicycles or go on foot. If all cars had to be luxury cars, very few of us would be able to ride in any sort of car.
With respect to doctors, a similar situation has been put in place. We have basically outlawed all Chevy doctors who focus on the less expensive minor health problems (which is, in fact, all that most people have) and are forced instead to use Mercedes doctors who charge Mercedes prices even for ailments that can be fixed by people with significantly less training.
This article is based on "The Economics of Risk and Insurance," a talk Professor Hoppe gave at Mises University 2004 and 2005, available in MP3.
- 1. Unless of course there is the motive on the part of the insured to subsidize other groups. If I am a fan of football players and do not mind paying a higher premium for their risk, then such a systematic income redistribution can take place.
- 2. Mises, Human Action, Chapter 6, Section 3.
- 3. "Interventionism cannot be considered as an economic system destined to stay. It is a method for the transformation of capitalism into socialism by a series of successive steps." Ludwig von Mises, "Middle of the Road Policy Leads to Socialism."
- 4. See Dale Steinreich, "Playing God at the FDA."
- 5. See Dale Steinreich's articles for Mises.org, "100 Years of Medical Robbery," and "Real Medical Freedom." See also Henry Jones, "How Medical Boards Nationalized Health Care."