Bryan Caplan  

Health Insurance and Reputation

Lie to Me, 2... Krugman on Canadian Health Car...
Here's an argument even I've found seductively appealing:
The problem with free-market health insurance is that if a customer develops a truly serious health problem, his insurance company will try very hard to weasel out of the contract.  At best they'll deliberately give poor service to the people who need it most, because they know that none of their competitors want to poach customers with serious pre-existing conditions.  At worst, they'll claim that you broke the contract somehow, and hope you die before your lawsuit gets to a jury.
It seems plausible, no?  If your condition is truly catastrophic, won't profit-maximizing health insurers struggle to "contain their costs" at your expense?

The problem with this argument is that it proves far too much.  The same argument applies to life insurance and home insurance.  You dutifully pay your premiums for years.  Then you suddenly die, or your house burns down.  What's a profit-maximizing insurer to do?  Say you died or the house burned down because you were smoking in bed, of course!  Can you prove otherwise?

Yet in practice, people almost never complain about disingenuous disputes with life or home insurers.  Why not?  The obvious explanation is that life or home insurance companies that shirk their responsibilities hurt their reputation.  It might seem profitable to reject expensive claims, but in the long-run, an insurance company that mistreats its expensive customers is going to have trouble attracting any customers at all.  After all, what's the point of buying insurance from a company that won't pay when you need it most?

So why would the reputational argument be any less convincing for health insurance?  I wouldn't choose an insurer that was known to abuse or abandon its sickest customers.  Would you?  And why would word of mouth, advertising, and other conduits of reputation be less potent here than in other lines of insurance?

I agree that there is a popular perception that health insurance is an unusually crooked industry.  My main explanation is that customers of health insurance companies have more latitude for unreasonable demands.  If your dad dies, the life insurance company owes you $X.  If customers ask for $X+1, the firm refuses, and no one sees this as proof that the free market can't be trusted with life insurance.  If you get sick, in contrast, it's hard for an insurance company to decisively prove that they've lived up to their agreement.  You can always insist on another expensive test, even if the insurer knows it's useless. 

Insurance companies want a good reputation for taking reasonable care of their customers.  However, they can live without a reputation for paying for everything, no matter what.  Some companies might want to be known as "generous," and charge their customers correspondingly higher premiums.  But most insurers prefer a reputation for decent but cost-conscious care.  If that means affordable premiums, customers will happily buy cheap - then complain if their budget insurer makes them wait or tells them no.

Am I saying that health insurance companies never play dirty tricks on their customers?  Of course not.  It's a big world, lots of bad stuff happens.  What I'm saying, rather, is that reputation works well even in industries where firms have big, lumpy liabilities.  There are plenty of examples.  What reason is there to think that health insurance isn't one of them?

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The author at The Liberal Order in a related article titled Differences In Insurance writes:
    Bryan Caplan explains the difference in perceptions between health care insurance and auto and life insurance. I agree that there is a popular perception that health insurance is an unusually crooked industry. My main explanation is that customers of h... [Tracked on July 27, 2009 11:23 AM]
The author at Chicago, Athens, and Jerusalem in a related article titled More healthcare tidbits writes:
    1. Greg Mankiw points to a CBO report regarding the impact on the deficit of the healthcare reform bill currently working its way through the House of Representatives. 2. Marc Ambinder reports on Bill Clinton’s criticism of the CBO’s recent... [Tracked on July 27, 2009 11:33 PM]
COMMENTS (25 to date)
Bill Woolsey writes:


Think about how it interacts with health insurance.

And especially regarding complaints about health insurance refusing to provide adequate coverage.

Devin Finbarr writes:

Most critiques of free markets can be better phrased as business plans. This critique is no exception.

In a free market, the optimal design for a healthcare company would be as follows:

The healthcare company would contractually guarantee that 80% of all premiums would go towards care. The other 20% would be used for administration, marketing, and profits. The healthcare company would be obligated to spend all 80%. A specialist would then be in charge of managing the costs of a pool of customers. The specialists only goal would be to allocate money in a way to maximize the health of the pool as a whole.

This type of healthcare company would have no incentive to deny care to increase profits. They would be legally and contractually prevented from doing so. If the company denies a procedure, that money must be spent on someone else’s care. Thus the incentive of the company is to maximize health, so that the company gets a good reputation, and gains more customers.

Of course, no insurance company today runs this way. A web of laws and regulations prevents such creative business plans. The problem with our existing system is not a free market run amok. The problem is that a guild and cartel system has grown up, with insurance companies, the doctors guild, and the hospital unions all lobbying the politicians to gain special advantage at the expense of the whole.

Steve Horwitz writes:


Isn't the failure of the reputational mechanism in health insurance markets a consequence of the fact that most of the insured don't choose their insurer directly, as we do with homeowners or auto? We take a job, and our employer decides who our insurer will be. What is the individual's recourse? I can complain to my employer but even then, I will be one voice among many and I can't really exit without leaving my job. The employer can only renegotiate annually, at which point my complaint may seem a small cost to pay for a good corporate deal.

If my auto insurer gives me a hassle, I can go get myself to the gekko place right away. Same with homeowners. Employer-provided health care dramatically weakens the power of exit and puts more emphasis on voice, a weaker reputation enforcer in this context.

So many of our health care problems are the result of the link to employment, itself an artifact of WWII government intervention and intervening tax law.

Eric writes:

Steve Horwitz beat me to it. I've changed car insurance companies three times in my life. There is one time I would have changed health insurance companies based on their failure to live up to their end of the contract if I could have but, alas, my employer had only one option. I know I could have gone "individual" and paid 4 times as much since my employer subsidized some costs, but that tradeoff wasn't worth it to me.

We need to get rid of the disparate tax treatment between individual and group insurance so that the government will stop paying employers to pay insurance companies to pay my doctors. How can I control them if I'm 4 stages removed from the actual payment decisions?

Dave Schuler writes:

There is some considerable distance between something possibly being the case and something actually being the case. Has there ever been a study that found that adverse selection was a significant driver of health insurance costs or availability? Not that it could be but that it was. That's not a rhetorical question. I'm asking because I want to know.

shayne writes:

The means of addressing this issue (and Woolsley's 'hypochondria' complication) is the same - restore health insurance to a role of insurance (protection against catastrophic financial loss) rather than insulation from health care costs.

First, with high deductible amounts - $10,000 to $20,000 per year range. And second, by insurance policies designed with maximum lifetime payouts - $1 Million is typical. Both are in place and available right now, but the political rhetoric continues to encourage folks to believe health care and health insurance are both synonymous and free.

Fenn writes:

I think Steve has a great point. Most people have few choices and one chance a year to switch.

Auto insurance companies are obviously worried about reputation. Turn on your TV and see how long you can go w/o seeing an ad.

Not the case for health insurance.

I do wonder which is more lucrative.

Mark writes:

That's an interesting argument in which I see two problems:

Health insurance is not like house or life insurance because the latter two have far less that could be disputed. Your house has been burgled or not, you are either dead or alive. Granted, there are exceptions like whether or not you committed suicide, but generally the cases are clear-cut.

With health care, it seems to be much more about the grey areas. For example I had a friend who fought for two years to get a type of surgery designed to cause her to dramatically lose weight. The insurer fought it on the grounds that it was cosmetic, despite the catalog of ailments her doctor confirmed it would help her avoid.

It seems to me that the long-term benefits of good health care and the drive to maximize this quarter's profits are diametrically opposed. What incentive does the health insurer have to make certain you stay healthy? It may reduce the need to provide expensive treatment in the future, but then again - why not just make the money now?

You assume that understanding reputation is open and easily available to all of us who seek to do business with an insurer. This is clearly not the case. It seems to me to be one of those blinders that economists have - the assumption that information is perfectly available and that the rational person will always pursue a rational course. We know that this is not the case.

Want to prove me wrong? Okay, show me whether Blue Cross is better or worse than Aetna. Not easy is it? Of course, you could argue that you only need to find those with really bad reputations. In that case, please show me one large health insurer that went out of business because of its poor reputation.

ryan yin writes:

Dr. Caplan,

Let me play devil's advocate here. Is your argument here more like an existence proof or a uniqueness proof? That is, it seems like you're arguing that there exists an equilibrium where the folk theorem holds and reputation solves the health insurance game. But at the same time, you seem to be giving an explanation for why no one believes reputation works, which seems to imply that the reputation solution isn't used. (After all, if no one thinks we're supposed to be playing the trigger strategy, it doesn't matter whether that strategy would work, right?)

I don't think that proves anything -- just that it might unwind this particular argument.

silvermine writes:

Yea, I think the one issue there is that people really *don't* have the freedom to choose their health insurer. Most people choose from 2-5 plans offered by their employer.

Hey! I have a crazy idea! Lets stop that.... Have some sort of, you know, "free market".

Mark writes:

Interesting quote from an article on The Big Money blog:

"Unlike almost anything else we buy, health insurance is not something we can simply get from another vendor. In writing policies, insurance companies require that you have continuous coverage, or else they will exclude coverage for all pre-existing conditions"

This seems to be a good way to obviate the reputation risk that Dr. Caplan is relying on above.

Full post here:

Peter Twieg writes:

Yet in practice, people almost never complain about disingenuous disputes with life or home insurers.

I'd say that this is probably explainable:

a) I don't know much of life insurance, but I'd be surprised if life insurance contracts had as many possible exemptions that insurance companies could invoke as health insurance contracts. Usually the terms are straightforward and don't have to cover a large number of contingencies.

b) There are probably more (catastrophic) health insurance claims than home insurance claims, and people care more about denied catastrophic claims than more routine claims for minor expenses. Notably, when a natural disaster strikes that hits a lot of residences at once, it's almost inevitable that you'll hear outrage over denied insurance claims for damages, as happened after Katrina.

poorlyconceived writes:

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eccdogg writes:

Don't know about health insurance, but I do know that reputation plays a huge role at the Re-Insurer that I work for.

Our company has cultivated a reputation for speedy no(few)questions aksed payments in the event of a loss. We pride ourselves on this as a company. We are also more expensive than many of our competitors, we can be because when it is time to pay we don't quibble.

However, the problem with health insurance is there is little to no real competition and thus little differentiation.

Noah Yetter writes:
Act 3

Very few people choose their insurer anyway, unlike with auto and home insurance, so how powerful could a reputation effect be? And it wouldn't work anyway if every insurer is equally underhanded. The underhandedness doesn't get competed away because of time inconsistency. Once you've got a customer who's about to become very expensive, it's too easy to give them the boot and save the loss.

matt writes:

Reputation doesn't work for a number of reasons. First people have short memories they forget. Second people aren't likely to know how systematically an insurance company is screwing their customers, they might here about one incident from friends and avoid the better company because they don't have an accurate view of reputation. Third most insurance companies are particularly bad, this is especially true with home owners insurance, (you are homeless and its hard to fight back, they make their offers for settlements so low, and fight you tooth and nail making you wait years if you object, people at state farm went to jail for that scam, look it up, big NYT article in 2006, do you remember it? did I even get the firm right?), all have bad reputations thus there are no good choices.

Fourth, bloggers may not realize it but most people are not as bright as them, and those people aren't effective getting their messages out when they are being screwed over. Insurance companies are predators and focus on the weak, they are happy to give good service to the loud and connected.

Fifth, I have no choice in health care. I can go with the company my employer chooses or pay more money and be more vulnerable to having my coverage dropped by going it alone. Reputation only matters if I can choose.

Health insurance is very different from most other markets because of the degree of price discrimination, and because shopping around isn't an option when you are too sick. Insurers have strong positions and get good deals from doctors and hospitals. You can't get those deals on your own. Big employers have strong positions and get good deals from insurers and protect their workers from being kicked off the plan when they get sick. You can't get that on your own, you buy coverage yourself you can get dropped. Dealing with insurance is like dealing with the mob, they only understand power, and if you have none, they will walk all over you.

Dan Weber writes:

Mark makes an excellent point: you are either alive or dead. Your house is either burned down or not. It's not too much trouble to go before a judge and say "my house is gone, make them pay." Plus with transactions that are few and big, the insurance company can afford to investigate fraud.

There is another: costs are known up-front to the life insurance company and fire insurance company. If Joe dies, his family gets N thousand dollars.

But if Joe comes down with lupus and his kidneys break down, he might need N thousand dollars every single year. That's a pretty open-ended liability.

Dr. T writes:

"If you get sick, in contrast, it's hard for an insurance company to decisively prove that they've lived up to their agreement. You can always insist on another expensive test, even if the insurer knows it's useless."

And even if your physician knows it's useless. My job is running labs, and when I've questioned physicians about ordering an expensive ($1000+) and seemingly unnecessary test, I often hear that the patient was pushing for it because she read about or heard about the test. The request is usually withdrawn when I state that the insurer won't cover the test. Health insurer denials often are clinically appropriate cost control measures. In the lab world, I rarely had health insurer denials of truly necessary tests (and I got them to cover the tests once I spoke with a medically-trained reviewer).

w0wy writes:

I think your premise is incorrect. I don't know much about life insurance but home insurance companies routinely send notice of non-renewal after frequent claims. They charge higher premiums for home with a history of repairs. They try to weasel out of paying as much as they can. So much so that the denied claims for Hurricane Katrina have spawned off a small industry for lawyers that fight these denials.

John writes:

"I wouldn't choose an insurer that was known to abuse or abandon its sickest customers. Would you? And why would word of mouth, advertising, and other conduits of reputation be less potent here than in other lines of insurance?"

The problem with this is that all insurers have the incentive to legally fight big claims. There is no competition with regard to reputation. For them to come out ahead, their legal fees must simply be less than what they'd pay for your claim. When they deny your claim, that's it, unless you sue. Because you have to find a plaintiff's attorney to take your case (which is actually not that easy), and they already have experienced corporate counsel, they have the advantage, procedurally and financially.

hacs writes:

"It might seem profitable to reject expensive claims, but in the long-run, an insurance company that mistreats its expensive customers is going to have trouble attracting any customers at all."

Yes, when there are options. The point is that all insurers do the same. Why?

Complementing the argument exposed above - "The problem with...gets to a jury." -, if a company behaves different, then it would attract mainly/firstly the sickest people, augmenting its costs; besides, it would be catastrophic to the reputation of that company to deny insurance to so many unhealthy people, worse after it signaled favorably.

Granite26 writes:

Is it possible that there is a group identification element to this?

By which I mean: Most people think they are excellent drivers, but they also have little faith in the ability of others to drive. When buying car insurance, it is under the assumption that someone else will hit you, and you will need the company to pay you money. The same is the case with homeowners insurance.

When you hear someone complaining about poor service in an auto claim, you'll pay attention, because you see yourself needing help with a wreck.

OTOH, when someone complains of poor health care service, it's likely that no one listening will see themselves as needing healthcare for that issue.

Just a thought...

Bill D writes:

Mark, home insurance is much less black-and-white than you think. For instance, if a fire destroys a quarter of my belongings, how is an insurance company to know what those belongings were?

Additionally, there will always be a gray area. Over time, people will spot trends in which companies tend to deny more gray-area claims and which tend to accept gray-area claims.

CM writes:

"Then you suddenly die, or your house burns down. What's a profit-maximizing insurer to do?"

In Colorado, after late 90s wildfires, many companies stopped offering policies. This may make sense for those who had built in dangerous areas, similar to flood insurance.

But, my house was in the plains. We had only a small brush fire, and only $7000 worth of damage. It was only damage to the landscaping, to remove a burnt tree and a row of juniper bushes; and a few shakes of the wood shake roof.

But, with a "fire" on our records, I current insurer refused to renew our policy. And, when I moved to Ohio, I had trouble both with finding a policy for the vacant house for sale in Colorado and for the new house in Ohio. The new house is in a township (rather than a generic suburb) and has a volunteer fire department.

Essentially, a $7K claim one time in my life at one residence now marked me as having a pre-existing condition and not able to find insurance. We were only able to get a quote by contacting the seller's insurance company, and then only by switching our autos to also be insured by that company.

Alex writes:

You fail to realise that health insurance is a monopoly in most US states. Car and life insurance generally aren't monopolistic.

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