In the comments section of my post yesterday on health insurance, “The Pre-Existing Elephant in the Room,” Erik Brynjolfsson, the Schussel Family Professor at the MIT Sloan School of Management, Director of the MIT Center for Digital Business, Chair of the MIT Sloan Management Review, and the Editor of the Information Systems Network, writes:

You say you think people should be responsible for the “costs they create” when they have pre-existing conditions, but aren’t most of those due to bad luck?

If so, would you favor a “perfect” market where everyone paid in advance 100% of their expected future healthcare costs? Wouldn’t that pretty much miss the whole point of insurance?

On his first question, which is a good one, I don’t know the answer. I’m sure some of it is bad luck. A key question is “When did the bad luck happen?” If it happened when the person was in his 20s or later, that’s the great advantage of buying health insurance early with a guaranteed renewable clause, a clause that existed in many individual health insurance contracts.

But take the extreme where it was all due to bad luck at an early age. To justify making others pay, you would have to argue that the bad luck should be forcibly put on others who themselves had no role in creating the bad luck. Here’s where I balk.

His second question, though, surprised me. The whole point of insurance without a loading fee (which economists sometimes call “actuarially fair insurance”) is to have the person pay 100% of his expected future medical care costs. Notice the word “expected.” I’m assuming Professor Brynjolfsson is using that word the way we economists use it: the probability of the expense times the amount of the expense. Of course, insurance will always be priced higher than that because of the loading fee, the amount the insurance company charges for running the business–expenses for advertising, offices, claims adjusters, etc.

So, contrary to Professor Brynjolfsson, this doesn’t at all miss the whole point of insurance. He seems to be thinking about insurance as a program for the low-risk people to subsidize the high-risk people. But here’s what his MIT colleague, economist Richard Zeckhauser, wrote about that in “Insurance,” in The Concise Encyclopedia of Economics:

An economist views insurance as being like most other commodities. It obeys the laws of supply and demand, for example. However, it is unlike many other commodities in one important respect: the cost of providing insurance depends on the identity of the purchaser. A year of health insurance for an eighty-year-old costs more to provide than one for a fifty-year-old. It costs more to provide auto insurance to teenagers than to middle-aged people. If a company mistakenly sells health policies to old folks at a price appropriate for young folks, it will assuredly lose money, just as a restaurant will lose if it sells twenty-dollar steak dinners for ten dollars. The restaurant would lure lots of steak eaters. So, too, would the insurance company attract large numbers of older clients. Because of the differential cost of providing coverage, and because customers search for their lowest price, insurance companies go to great pains to set different premiums for different groups, depending on the risks each will impose.

Zeckhauser goes on to point out that the problem of adverse selection arises precisely when insurance companies cannot distinguish the high-risk people from the low-risk people, when the high-risk and low-risk people know what risk category they are in.