The economic function of insurance is to transfer risk that we cannot afford to retain. It is a very simple concept. Young parents, for example, may be totally confident that “as long as I am around” their kids will have all the opportunities life has to offer. The whole thing falls apart, however, if a parent dies before an estate can be built. To avoid such a devastating outcome, prudence dictates that this risk be transferred to a life insurance company. With life insurance, an estate would be provided in the event of a parent’s premature death. When the kids grow up and an estate is built, life insurance is typically no longer needed.
Again, there is nothing complicated about insurance. Since the concept of transferring the risk of a catastrophic event is so intuitive, it is puzzling how the purpose of insurance has become so misunderstood by so many. The insurance industry can take much of the credit for this confusion. They have done a masterful job of convincing us that we should transfer virtually all of life’s risks to them. The most outrageous example is their marketing of life insurance on kids. First, let me state that if I lost any of my kids, I doubt I would ever fully recover. My life would be dimmed forever -- but I would never have life insurance on them!
Why? Because kids are not financial assets. Quite to the contrary, my kids are three of the biggest cash suckeruppers this world ever saw. I would be much better off financially if I didn’t have them. Why would anyone insure a liability? Clearly, the premiums would be better used if they were invested in a fund on which the family could draw to pay final expenses (if that were to ever be necessary). If the balance of the fund turned out to be inadequate, the remainder could be borrowed and the money saved (and this sounds so cold) from not having the kid around anymore would quickly pay off any loans that may be needed. Flying in the face of sound economic reasoning, insurance companies have still managed to convince many parents that having life insurance on their kids is not only necessary, but a measure of their love for them.
We have also lost sight of the purpose and function of health insurance -- and in a big way. The economics is no different from other types of insurance. Yet, much like life insurance for kids, things have gone haywire.
There are many events that are fairly predictable and can easily be budgeted for. With great certainty we can assume that we will, on occasion, have to see a doctor for head colds, sore throat, minor injuries, etc. We may from time to time need to buy some medicine to speed our cure and make ourselves more comfortable. But, does the risk that we may catch cold really need to be transferred to an insurance company? Insurance companies are highly skilled at estimating probability and risk and they will not sell policies that cover these events unless the premiums are high enough to provide them a profit. Comprehensive policies cover these high frequency/low severity losses, and as a result, premiums must be higher to cover the additional administrative expenses. Insurance companies love to sell policies that cover such predictable events and agents are paid higher commissions for selling them.
However, it is more cost effective for the insured to retain the risk for these high frequency/low severity losses through the use of higher deductibles. This way, the cost of covering the administrative expenses can be reduced since the insurance is now focused on low frequency/high severity losses which also require less frequent administrative red tape. However, insurance companies (and now politicians) have been masters at convincing us that these high frequency/low severity situations are too risky for us to bear. Thus we see comprehensive policies sold where high deductible policies would be more efficient. (I do wonder when we will see haircut insurance. Wouldn’t it be nice to just give the beautician our insurance card whenever we get a trim? How about rain insurance? If we find ourselves stranded away from our car without an umbrella, all we would have to do is call a hotline and an umbrella would be delivered to us. We could forever eliminate the risk of getting wet!)
For those who are highly risk averse or have trouble managing their finances, perhaps big expensive coverage is a good idea. For those of us who are already expending a great deal of resources in health maintenance, the last thing we want to do is to pay to transfer risks that we have already worked hard to minimize. There are many, like myself and my family, who take health seriously enough to do everything possible to take care of themselves through proper eating, exercise, and by avoiding harmful substances like alcohol, tobacco, and illicit drugs. These prevention measures, however, are not without cost. Health club fees, food supplements, fitness equipment and maintenance (bicycles, running shoes, etc.) really add up. Good physical fitness is a major investment in time and money. With a comprehensive policy, we are effectively paying twice: once to transfer the full risk to the insurance company, and then again to minimize that very same risk we just paid to transfer.
It is therefore unfortunate that under the Affordable Care Act (aka Obama Care) many high deductible policies will not be allowed. Yes, our politicians in their infinite wisdom are ignoring economic reality and forcing us to purchase more insurance than we need. This is like a hungry man being forced to buy a whole herd of cattle just to get a Big Mac. He really needs the food but having to buy the whole Ponderosa is a serious financial burden. Of course, big, expensive comprehensive policies should be available for those who want them but they should not be the law of the land. Yes, everybody needs health insurance. The risk of catastrophic illness or injury is too great to self-insure. On the other hand, the risk of getting a head cold and needing some antibiotics is quite manageable and does not need to be transferred to an insurance company.
So why does the Affordable Care Act (aka Obama Care) require more insurance than is needed? Because this is more about redistributing income than it is about health care.
The ACA is built around the hope that by forcing the young and healthy to buy insurance, those funds can be used to pay for the health care of the sick and elderly and those with pre-existing conditions. The trick is to get the young to buy in. Unfortunately, because they will be forced to purchase more than they need, many will find it too expensive (except for those who are well connected politically, of course. Young White House staffers, for example, have been exempted because it has been determined that it will cost too much).
Financial Analyst Dan Caplinger explains further in the video below:
If twenty and thirty somethings opt out, where will the money come from to support the system? More taxes and more debt with the resulting drag on economic growth and standard of living. This is when the Affordable Care Act becomes even more unaffordable. (For more about the ACA's not-so-pretty fiscal picture, see: realclearmarketsobamacarefinancialunraveling)
With the new system breaking the bank and so many remaining uninsured, we will begin hearing arguments for a Canadian style single payer system – with all its accompanying shortages and backlogs. (This would have to be disconcerting for Canadians who have always had the U.S. as an outlet when wait-times have become too long. For example, Cleveland is now Canada's unofficial hip replacement center and the government of British Columbia had to contract with Seattle hospitals when the back log became too great. Where would Canadians go if the U.S. implemented the same system?)
Canada's Frazier Institute tracks wait-times for health care. See:
http://www.fraserinstitute.org/research-news/news/display.aspx?id=16488
More about the ACA in future posts.
MM
