David R. Henderson  

Pooling Risks

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John Goodman posted yesterday on another post by law professor Jill Horwitz and economics professor Helen Levy. In their post, Professors Horwitz and Levy defend Obamacare from various criticisms. I won't bother repeating John Goodman's arguments. Rather, what I note is that their criticism repeats two common misunderstandings about insurance. They write:

Taking these two features of the law into account, it is not clear there will be much redistribution from young to old as a result of the ACA [Affordable Care Act] at all. There will, within each age group, be pooling of good and bad risks; by definition, this is how insurance works, and as noted above is a more efficient outcome than one in which markets do not exist because of adverse selection.

Actually, this is not how insurance works ideally. Insurance works by pooling equal or close-to-equal risks. A 90-year-old man, for example, will pay more for life insurance than a typical 25-year-old man. The reason seems obvious: the risk of a payout is much higher for the 90-year old than for the 25-year old. Similarly, a 21-year-old man will pay more for car insurance than a typical 50-year-old man. So the insurance company will invest in information to ascertain risk and will price accordingly.

Which brings me to their second error. They write that the pooling of good and bad risks "is a more efficient outcome in which markets do not exist because of adverse selection." But the pooling of good and bad risks is the essence of adverse selection. Adverse selection arises because of asymmetric information: in the extreme, the insurance company cannot distinguish between good and bad risks and prices the same to everyone. Low-risk people, except the most risk-adverse among them, respond by not buying insurance; high-risk people find the insurance a good deal. The solution is for the insurance companies to figure out low-cost ways of ascertaining people's risk and then to price higher to high-risk people and lower to low-risk people.

Disclosure: I am one of the signers of the brief that Professors Horwitz and Levy criticize.


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COMMENTS (23 to date)
Greg G writes:

There are people who would prefer to settle their disputes without pooling the risk and having the government provide a court system and law enforcement. They object to having their income redistributed to pay for a court system they do not wish to pay for.

There are people who would prefer prefer not to pool the risk from a foreign military invasion. They object to having their income redistributed to pay for a military they do not wish to pay for.

There are people who would prefer not to purchase health insurance. When they get sick and require more health care than they can pay for, they usually get that health care anyway and leave the rest of us to pay for it.

MikeP writes:

There's even a third error.

Insurance is a way to arrange another party to pay for large and unexpected expenses.

But Obamacare (a) specifically mandates coverage of predictable and inexpensive health care and (b) requires that 85% of an insurance company's outlays go to the provision of health care, an almost impossible proportion for a company providing catastrophic insurance where medical costs are lower and decision making is higher.

So regardless of its other benefits, the ACA destroys insurance markets right and left, rendering "a more efficient outcome than one in which markets do not exist because of adverse selection" pretty weak tea.

MikeP writes:

There are people who would prefer not to purchase health insurance. When they get sick and require more health care than they can pay for, they usually get that health care anyway and leave the rest of us to pay for it.

And these people cost society a pittance compared to the disaster that Obamacare is.

Total costs of uncompensated care of all types are 40 billion dollars per year and do not impose vast inefficiencies on the health care system. The new burdens of Obamacare, in contrast, are far more expensive and far less efficient. The government's citing uncompensated care as an excuse for redesigning the health care system was extremely cynical and puts the lie to the whole effort. There are far cheaper ways to deal with free riders than mandating and subsidizing median income households to buy overly generous insurance -- the current mechanisms for paying for the uninsured being only one example.

Devil's Advocate writes:

Prof H.,

I agree with your points on the "pooling" of like-risked individuals...it is ideal. But, in the un-ideal world and in aggregate, pooling all does spread the risk. One thing that complicates it more is the likelihood (and ideal) event that the 25-year old will, with time, become a 90-year old.

Greg G writes:

Mike P,

If you are really focusing on efficiency, rather than fairness, I think the fee for service model and having health insurance tied to employment would be more promising places to direct your attention.

MikeP writes:

Greg G,

No doubt. Then again, Obamacare didn't address those in the least while it used free riders as an excuse to impose far more costly problems on us all.

rpl writes:

David,

I think you're slightly mistaken when you say, "the insurance company cannot distinguish between good and bad risks and prices the same to everyone." By and large, insurance companies are pretty good at figuring out what an individual's risks are by looking at their medical history. If the were legally allowed to, they would be happy to price coverage accordingly. However, the public hates that prospect. They want to use insurance to make transfers from healthy people to sick people, and politicians are more than happy to concoct all manner of half-baked schemes to give them what they want, most of which (as MikeP observes in his first post) are worse than just making honest transfers.

David R. Henderson writes:

@Devil’s Advocate,
One thing that complicates it more is the likelihood (and ideal) event that the 25-year old will, with time, become a 90-year old.
This doesn’t complicate it. I bought a 10-year-term life insurance policy for $750K when I was 48 and paid x per year for it. It expired. I then bought a 10-year-term life insurance policy for $300K when I was 58 and paid y per year for it. y/$750K was substantially greater than x/$300K.
@rpl,
I think you're slightly mistaken when you say, "the insurance company cannot distinguish between good and bad risks and prices the same to everyone."
If I had written what you quoted me as writing, I wouldn’t be slightly mistaken; I would be very mistaken. The line you quoted is from the paragraph that explains adverse selection. Like you, I think the insurance companies do a pretty good job of ascertaining risk and pricing accordingly. That’s why the adverse selection problem, when they’re allowed to price for risk, is not large.

Greg G writes:

Mike P,

It is certainly true that the bill prioritized increasing the number of people covered over addressing problems with the fee for service model. It is not true that it "didn't address those in the least." It provides for a pilot program to begin moving Medicare off the fee for service model.

More reform in this area would have been desirable but was not possible politically. Every bit of inefficiency in the current system represents income to someone who will fight tenaciously to keep it.

rpl writes:

David,

I see. I read that paragraph as though you were arguing that adverse selection is a big problem in practice. Thanks for clarifying.

Hasdrubal writes:

Are you familiar with the "advantageous selection" literature? I.e. the standard model of insurance requires everyone to be equally risk averse but to have different risks in order to get a downward sloping marginal cost curve, making it most efficient to ensure everyone. But in the real world, some people are more risk averse than others, and those who are more risk averse tend to a.) be more likely to minimize their personal health risks AND b.) to be more likely to buy insurance. When you allow heterogeneous levels of risk aversion, you can get an upward sloping marginal cost curve.

If this is the case in the health insurance market, the adverse selection argument goes completely out the window.

I first read about this in the JEP article "Selection in Insurance Markets: Theory and Empirics in Pictures" by Liran Einav and Amy Finkelstein. ( http://www.nber.org/papers/w16723.pdf?new_window=1 )

Devon Herrick writes:

Public health advocates often say... "health coverage can never be affordable until everyone has coverage!" Dr. Henderson points out how foolish this is when he says... "Insurance works by pooling equal or close-to-equal risks."

When liberals repeat this myth, they are not talking about efficiency or economics of scale. Rather, they are erroneously suggesting that forcing young, healthy people into the same risk pool with older, less healthy individuals will somehow make health coverage more affordable. This is not true; it merely increases the cross-subsidy, in the process making health coverage a bargain for those with higher health risks and unaffordable for those with few health risks.

Over time healthy individuals drop out of the insurance pool because they are being gouged. Premiums (again) become unaffordable for the unhealthy, since that’s all that’s left in the risk pool. That’s what the individual mandate is for: to force people to do something they are too smart to do when allowed to make a choice on their own.

To be insurable, risks need to be relatively equal among individuals and also of an unknown nature. Once a risk is a certainty, it's no longer insurable.

A better way is to have individuals pool their own health risk over their working lives. Excess funds accumulated in an HSA while young could be used to offset the higher costs of insurance when old. This is similar to the lifecycle theory of investing for retirement.

CK writes:

To Greg G.:

It is inappropriate to make a comparison between courts of law, military defense, and health care. Courts of law and defense protect your rights whereas healthcare (or the availability of insurance in this case) protects nothing, rather it provides a service. If you have been wronged or a victim of some sort, a court will protect you from someone trying to take something away from you that is yours (e.g. your property or your life). A national defense, again, protects you from some entity taking something from you (e.g. Your country, your property, or your life). On the other hand, the service of healthcare does nothing to protect you from having your rights infringed upon (i.e. Somebody taking something from you). An individual has no right to somebody else's work; therefore, if someone is not providing you with healthcare, or even insurance in this instance, your rights are not being infringed upon (the government is not protecting you from somebody else taking something fromyou). You are comparing two unlike things. Courts and defense protect rights. Healthcare is merely a service.

collin writes:

My question would be

1) Why do individual insurance policies have more age appropriate premiums set? I know there is some government interference here but health insurance has been sold to individuals over 70 years.

2) Of course there is the dreaded issue of pre-existing conditions. To a consumer pre-existing conditions limits the purchase choices while insurance company need them to control their risk.

3) From reading Tom Coburn's interview about health care, it seems most providers like the full service system. Should we stop forcing the emergency room from having to save anybody who comes in? This would be a good test of whether charties are as effective as conservatives claim.

CR

Greg G writes:

CK

You think it's fine for government to coerce people into paying to protect the rights that are important to you. Other people think it is fine for government to coerce people into paying to protect rights that are important to them.

You arbitrarily choose to define life saving healthcare as "merely a service." Those facing death as a result of some life threatening medical emergency are more likely to consider it part of a right to life.

We should not be surprised that people disagree on such matters. Elections in a constitutional democracy are the best method for settling such disputes.

CK writes:

Greg G

I personally don't think it's fine for the government to coerce people to do anything. The methods of collecting funds and protecting rights are related but different issues in this case. I am personally against any income tax, which is the government coercing individuals out of their money. I am however, in favor of funding methods such as user fees (individuals voluntarily paying for services or products) and sales taxes (which can be viewed as a fee for upholding a voluntary sales contract). But funding methods aside, I also view a government of the people as an extention of the people it represents. If an individual cannot do something, then neither can it's representatives. For example, I cannot kill or enslave anybody, so neither can the government. It makes no sense to me that if I hire somebody to steal something for me, I would go to jail. However, if I vote for somebody to steal for me, that is called democracy. With that in mind -, whatever I have the right to do myself, I can hire the government to do for me. I have the right to protect myself and my property from harm, therefore I can hire the government to provide for a justice system or defense to also protect myself and my property. I do not however have the right to force somebody to work for me (cure my illness or save my life), that would make that person my slave. In that same token, neither should the government be allowed to force somebody to provide their work (healthcare or insurance). Kind acts such as saving somebody's life should be done through somebody's own virtue. An act loses all virtuousness if if it is carried out via any force. If one thinks that healthcare should be provided by a doctor or hospital or funded by a certain entity or individuals, then one should try to persuade or use a public voice to try and convince them to provide an act of virtue.

Bob Murphy writes:

David,

Of course I agree with the overall thrust of your post, but I think you might have misread them when they wrote:

There will, within each age group, be pooling of good and bad risks; by definition, this is how insurance works, and as noted above is a more efficient outcome than one in which markets do not exist because of adverse selection.

Maybe they're not dotting their i's exactly right in the above, but I think I know exactly what they are trying to say and it's not obviously a "second error," as you describe it.

They're looking at something like these two different outcomes:

(A) 60-year-olds with hidden health conditions and 60-year-olds in perfect health are all forced to get health insurance. Because of competition, insurers charge the premium based on the group's risk as a whole, and even though this involves a subsidy from the healthy people to the ones with health problems, everybody still gains. That's how much the possibility of insurance benefits a person, that even a healthy person would rather pay higher than his actuarially fair premium (given perfect information).

(B) People are allowed to forego health insurance if they don't want to buy it. Now, if the insurer charges the same premium as before, some of the healthy ones opt out, and then insurers can't stay in business. So they have to raise premiums. But this exacerbates the adverse selection problem. In a pool of mostly sick 60-year-olds, it just doesn't pay to offer insurance; nobody could afford the correct premium. But because the health conditions are unobservable, we can't get a separating equilibrium either, with different premia charged. Instead nobody gets insurance.


David, I admit something is a little off in my analysis above, because it's not clear why people are opting out in scenario B, if (by stipulation) people are happy in (A). However, another way to see their point: If insurers knew with certainty who would get sick and who wouldn't, then there would be no insurance. In that case, people who were destined to get cancer would be up a creek, and everybody else would save on a lifetime of high premium payments, etc.

Justin writes:

You think it's fine for government to coerce people into paying to protect the rights that are important to you. Other people think it is fine for government to coerce people into paying to protect rights that are important to them.

Greg G, I think you need to learn to distinguish between what is a right and what is a good*. Freedom of speech is a right. Courts and armies exist to protect rights. Health insurance is good. Your second sentence above should read:

Other people think it is fine for government to coerce people into paying for goods that are important to them.

Now if our Constitution enumerated ownership of a health insurance policy as a fundamental right then your statement might be valid, but that is not the case.

(*I'm using good/service interchangeably here)

CK writes:

Greg G

I don't think it's fine for the government to coerce people to do anything. Forms of government funding and protection of rights are related but different issues in this case. As to funding, I personally am against any form of income taxes, which is the government coercing people out of their money. I prefer government funding to come from sources such as user fees (people voluntarily paying the government for a good or service) or sales taxes (which can be viewed as a fee charged by government in exchange for it enforcing a voluntary sales contract). But funding issues aside, I also believe that a government of the people is nothing more than an extension of the people it represents. Therefore, if an individual cannot do something, neither can the government that represents him. For example, if I cannot kill or take from somebody, neither can the government kill someone or take his possessions. If I pay someone to steal something from someone else for me, I go to jail. However, if I vote for someone to steal something from someone else for me, that is called democracy. I have never understood how this can be morally justified. With this in mind, one must look to what is okay for an individual to do and then conclude that it is acceptable for that individual to hire the government to do the same. If it is okay for me to protect my life and my property, then it is okay for me to pay the government to provide a justice system and defense to also protect my life and my property. However, I cannot force somebody to work for me, to provide me with his services. Enslaving an individual infringes on his right to his property (his work). In turn, I cannot pay the government to do the same (in this case, forcing people to provide healthcare or insurance for healthcare). Providing a service such as healthcare, free of charge or at a severely reduced rate, is an act of virtue. The act loses all virtuousness if it becomes a forced act. If it is desired that a hospital or doctor provide a service, or an entity or person pay for such service, then peaceful persuasion of any means should be used to accomplish this end, never coercion. One last thought, healthcare (or the funding of healthcare in this case) is not a right. A right is something that is inherently yours and cannot be taken away through force or coercion. The only things that are rights are life, liberty, and one's justly obtained property (not stolen). If no one existed on the planet except for a single individual, then that individual would still have all three of these things. However, that individual would not have healthcare. Why? Because that would require the services of another individual. One cannot have the right to something if it requires forcing another individual to do something.

Devil's Advocate writes:

Re: David R. Henderson writes: This doesn’t complicate it. I bought a 10-year-term life insurance policy for $750K when I was 48 and paid x per year for it. It expired. I then bought a 10-year-term life insurance policy for $300K when I was 58 and paid y per year for it. y/$750K was substantially greater than x/$300K.

How about paying ((X+Y)/2)/(($750K+$300K)/2) over a 20-year period? My hunch, is the actuaries would find the premium too high, and lower it...due to spreading the risk over a larger timeframe. Agree?

Greg G writes:

CK

You have given a carefully reasoned view of your opinion on these matters. Thank you for that. I agree that is your opinion. Once you get outside of this blog, it is very much a minority opinion and always has been.

As you indicate at the end, if a person lived on a planet all by himself, he would exist in a state of perfect libertarian liberty. But no one would ever choose to live in such a condition by himself.

We don't just care about the absence of constraints. We also care (even more) about the presence of desirable options. This requires collective action and compromise with people who hold different values. For all its many faults, constitutional democracy is by far the best method of dealing with this problem.

You can react to that with a lot of hand wringing about our failure to achieve some utopian state you think you are entitled to or you could appreciate the fact that we live in the most free and prosperous state in human history.

CK writes:

Greg G.

I agree with you that my opinion is currently a minority opinion, but disagree that it is "very much a minority opinion." Even if it may be an opinion in the minority, it does not mean that it is not something our society should strive for. Also, it has not always been a minority opinion. At least in the small history of this country, it was not until the progressive era that it became a minority opinion. The 18th and 19th centuries (in the U.S.) were dominated by political thought that more closely resembled classical liberalism as opposed to modern day liberal ideology.

I only use the scenario of a lone individual to demonstrate a point. Obviously no one would choose to live in such a manner. I was just trying to break things down to their simplest form in order to demonstrate the difference between a right and a good or service.

I would also argue that a constitutional democracy, collective action, and compromise in themselves can be very dangerous and are definitely not the best method for dealing with any problem. It may be the easiest method (majority rules is always easiest), but whether or not the outcome of democratic action is good or just, solely rests in the morality and intentions of the people participating in the democratic process.

To offer another simple scenario - Suppose some time in the future we become overpopulated, so the people in our democracy, in their infinite wisdom, decide to pass a constitutional amendment prohibiting having more than one child, and any additional children will be killed. This of course sounds ridiculous, but if the people in a democracy demand it, it can happen. Does that make it right, or the best method of dealing with the problem? Hardly. Caring more about the ends than the means can be very damaging to any society. The best way to deal with any problem, is through a society that respects and protects the natural rights of individuals and upholds voluntary contracts.

Additionally, I do not think I am entitled to any kind of "utopian state." I do however believe that I am entitled to my rights (life, liberty, and my property). Just because we live in "the most free and prosperous state in human history," does not mean we should not strive for more freedom and prosperity.

I respect your point of view (and any reasonable point of view for that matter) mostly because I used to think the way you do (or at least how I perceive you think because obviously I don't know you and couldn't possibly know how you think based upon a few blog posts). However, "appreciat[ing] the fact that we live in the most free and prosperous state in human history" is just a cop out. One should never sacrifice his principles simply because it's easy, it's pretty good right now, or because that's just the way things are. I would hope you, and everyone for that matter, would strive for maximum freedom in all areas of life, and not only apply freedom in all areas except those dealing with finances.

Ken B writes:

@Bob Murphy:
I think your point is stronger than you do!

They are asserting that adverse selection will exist and will prevent the formation of a market. Under that assumption forcibly corralling all the possible insurees regardless of risk will still allow a market to form. They see this as more efficient even if some of the corralled insurees would like to opt out.

In other words I think they are asserting that they don't care that not everyone is happy in A, because there is a significant net gain.

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