Insurance: what it is, and what it is not
Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating loss.
Only some future events are insurable. Insurable risks share certain characteristics: the risk of a single loss is small, the insured cannot cause the insurable event to occur, the magnitude of a potential loss would be too great for the insured to afford, and when the risk is spread over a large number of similar cases, the premium for each insured is affordable.
For market conditions to make insurance a sensible model, a risk must meet all of these characteristics. It would not make sense to obtain insurance against a certain expense – even it were possible – because the premium paid to the insurer would be equal, or greater than, the expense itself. Your house burning down is an insurable risk, while your car running out of gas or your pantry running out of grocery supplies are not…
One of the many bad side effects of the current system is that the meaning of the word insurance has become corrupted in public discourse. The way that the word is used in the current debate means, approximately, “a third-party payer who will provide unlimited health care at minimal or no cost to the patient.” I frequently hear people ask, “how can someone with an illness obtain insurance?” What the sick person needs is care, not (necessarily) insurance. In any case it would not make sense for an insurer to provide a policy to someone who is already sick.
When I blogged about this recently, I received several emails with questions along the lines of, “I have medical expenses that I cannot afford, therefore I need insurance.” But insurance as such can only replace large unpredictable risks with small but known payments by distributing the small risk over a large pool of insured. Insurance cannot solve the problem of funding all routine or regular care because distributing a fixed and even expense does not reduce the cost – it probably increases the cost. A policy that covered predictable and recurring care would have to charge at least as much as the care itself, and then some to account for the overhead of claims processing. The insurance company must prevent fraud and ensure that the care they are paying for is necessary. This imposes additional monitoring costs. For the people who emailed me, a policy would only reduce costs if someone else paid the premium…
The present debate about health care reform must not remain a debate about insurance reform. We should be talking about what is the best system for everyone to obtain care at a reasonable price. Insurance plans with high deductibles and low premiums might be part of the solution. But the word insurance should not be used to mean the same thing as care itself.
All of the energy that is presently expended arguing about insurance has crowded out the more fruitful discussion of alternative payment models, including a cash payment system directly from consumer to provider.
