Tuesday, April 24, 2007

How Does Insurance Spread Costs?

An April 24 article from The Denver Post, titled, "Senate tentatively OKs health-insurance bill," quotes State Senator Bob Hagedorn: "The purpose of health insurance is to spread the cost." Hagedorn is a sponsor of House Bill 1355, which would repeal moderate "ratings flexibility" for employer-paid insurance. Former legislator Mark Hillman, who backed the "ratings flexibility" in 2003, believes that the flexibility enabled more employers to offer insurance.

There is an element of truth to Hagedorn's statement. As I've written: "[P]erhaps it would be helpful to remind ourselves of why people started buying insurance in the first place. It makes sense to insure ourselves against unexpected, high-cost risks such as premature death, a costly disease, the destruction of our home, or a serious car wreck.

"The point of insurance is to get it before we know whether we'll need to make a claim. People pool their premiums, then whoever suffers the harm gets the payout. If everybody has the same risk, then everybody will be willing to pay the same premium. But people at a lower risk won't agree to subsidize somebody with a higher risk. For example, a safe and healthy 25-year-old won't voluntarily pay the same amount for a comparable life-insurance policy as is paid by an older person who has cancer and enjoys drag racing."

So insurance does "spread the cost" in the sense that people voluntarily pool their risks and their premiums. Then the costs of the damage suffered by a few are spread out among all the premium payers. That's the way insurance is supposed to work, and people voluntarily sign up for it.

But that's not the sort of cost-spreading that Hagedorn is talking about. After the federal government pushed most insurance into the high-cost, non-portable employer-pay system via tax distortions, the federal and state governments subjected employer-pay insurance to community ratings and guaranteed issue. The explicit purpose of these measures was to "spread the cost," not by allowing people to voluntarily pool actual risks and (individually adjusted) premiums, but by forcing those with lower risks and costs to subsidize those with higher risks and costs.

Thus, what Hagedorn is talking about is not really even insurance. It is a combination of insurance, health "insulation" (to use Arnold Kling's term) and coercive wealth transfers.

Though one wouldn't know it from Hagedorn's quote in the Post, there is all the difference in the world between voluntary cost sharing and cost sharing that results from political force.