When Does Insurance Make Sense?
When does it make sense to use an insurance model, and when is an insurance model less useful? After all, it clearly doesn’t make sense for most of our transactions to be done through an insurance model. We don’t make our food choices using grocery insurance, nor do we buy movie or concert tickets with an entertainment insurance policy.
An initial answer one might give is that we should use insurance to cover highly expensive transactions. But this isn’t quite right. Something being expensive does not, in and of itself, make an insurance arrangement sensible. This is because many things which are expensive are also reasonably predictable. An insurance arrangement makes sense for events which are high cost, low probability, and not predictable at the individual level. To give it a pat description, insurance make sense for events that, individually, are a matter of if, not when, but at the population level, are a matter of when, not if.
Consider homeowners insurance as an example. There are a lot of expenses that come with owning a home, but not all of them are typically covered with insurance. Depending on construction materials, most homes need to have their roof replaced every fifteen to twenty years or so. Replacing a roof is very expensive, but most homeowner insurance policies don’t cover this kind of repair. That’s because needing to replace the roof of your house isn’t a matter of if, it’s just a matter of when. These kinds of easily anticipated expenses are best met through savings, not insurance. This is in contrast to, say, a house burning down. Whether or not your house burns down isn’t a matter of when, it’s a matter of if. Statistically, your house probably won’t burn down. But from the point of view of the insurance company, covering many tens of thousands of houses or more, that somebody’s house will burn down isn’t a matter of if, it’s just a matter of when. This difference in predictability, rather than total expense, is what explains when it makes sense to use insurance or not. And it’s also why a relatively small house fire that causes $5,000 in damages will be covered by insurance, but a roof replacement costing $20,000 typically will not.
Thinking about it in these terms, we can see places where comprehensive homeowners insurance doesn’t make sense – places where a home suffering major damage isn’t a matter of if, it’s a matter of when. There are areas in the United States where particular kinds of natural disasters are all but guaranteed to occur on a frequent basis – hurricanes, or major flooding. If you live on the Atlantic coast in Florida, your home getting hit by a hurricane isn’t really a matter of if, it’s just a matter of when. In a free market, we’d expect to see fairly little insurance for this, and instead people who choose to buy homes in areas with such well known and easily predictable risks would also be responsible for the repairs their homes will regularly and predictably need. Instead, areas with high risk levels see the insurance markets heavily distorted through subsidies that making living in high-risk areas artificially cheap by compelling others to foot a significant portion of the bill for the risks the residents choose to take. This creates a situation where the market is sending a clear signal saying “Hey, maybe don’t build lots of expensive infrastructure here” and legislators respond by saying “Counterpoint – maybe do build lots of expensive infrastructure there, and then when the inevitable and easily predictable results come about, you can just pass off the majority of the costs to your fellow citizens!”
Health insurance, as it currently exists, also makes little sense when viewed through this lens. In a free market, we would expect health insurance to cover treatment for conditions that aren’t a matter of when, but a matter of if. It would be used for cases like car accidents, where you suddenly and unexpectedly have large injuries needing immediate care, or for someone who develops cancer or needs an organ transplant. But it wouldn’t (and doesn’t) make sense for ordinary, predictable health maintenance and routine care to be provided though an insurance model. Some people might think we need health insurance for this because even routine maintenance can be so expensive, but I would argue that causation goes the other way – routine, commonplace health maintenance is so expensive because so much of it is covered through an insurance model.
Imagine if, due to subsidies and legal regulations, even the most routine car maintenance had to be covered by auto insurance. Need an oil change, or some new snow tires for the winter? Imagine having to check around to see which auto shop is in or out of network for your insurance company, trying to determine which sets of tires your policy covers and to what degree, working out what your deductible will be for the tire installation, and never even bothering to ask about the full price of the process, because you don’t ever pay the full price. And suppose you met your out-of-pocket maximum for auto insurance for the year! You’d have every reason to take your car into the shop as many times as you could for the rest of the year. This is one reason why health care reform that’s dedicated to making health insurance even more widespread and even more comprehensive is all but certain to make the problems with our health care system even worse.
Insurance can be a great tool, but it’s just a means to an end, not an end in itself. Making insurance more widespread and more comprehensive is not automatically a good thing – but as a soundbite, it’s very politically popular, and unfortunately that tends to be what carries the day more often than not.
Feb 27 2023 at 2:25pm
On the home insurance topic, it wouldn’t necessarily mean not building homes in disaster prone areas, but building them differently. An insurer in a free market could require much more stringent building standards and surfaces resistant to flooding. Or, they could go the other way. People could build houses without insurance even though they expect occasional catastrophes. In those cases, they might build them much cheaper. In earthquake-prone Japan, houses were historically built to very low standards and depreciate in value because people expect to need to replace them after a few decades.
On the health insurance topic, I’ve seen some people argue that routine check-ups and basic care must be covered otherwise people will leave conditions untreated and they’ll end up needed catastrophically expensive care as a result. I think another way to deal with that would be to condition catastrophic care plans coverage on the requiring the insured to follow basic standards of care, like getting annual checkups. To re-use your car analogy, you’re warranty isn’t going to cover engine repairs if you never change your oil.
Feb 27 2023 at 3:44pm
Or look at the older beach houses in the mid Atlantic. 20-25 years ago there were a lot of small beach cottages in Nags Head and Isle of Palms. Today, they have almost all been replaced by luxury beach houses.
The original ones looked like something that could be cheaply repaired or replaced after a hurricane.
Feb 28 2023 at 1:47pm
The point of making check-ups cheap/costless is not to protect the individual, but to protect the pool. People who economize on check-ups accrue 100% of the costs they don’t incur for the check-ups, but shift a large part of the risk they run onto everyone else in their risk pool. To address this adverse selection problem, the risk pool subsidizes check-ups and catches problems before they get big, rather than to have people economize on check-ups and then have the pool pay for big problems after they arise.
With that said, Barbieri has identified an alternative way to address this problem:
I like that! But either way, the point is that we arguably need SOME policy to address the adverse selection problem.
Feb 27 2023 at 2:41pm
Health insurance in the US is partly a tax and subsidy model, in place of a national or state-level explicit tax and subsidy. The system is designed to penalize non-insurance, except sometimes when you refuse to pay, or when you choose to negotiate after the fact. Politicians don’t want to raise taxes, so they force insurance companies to cover something else or make changes to their plans, under the guise of giving us all more stuff. Then the greedy insurance companies get blamed for raising rates, and not the politicians.
Market based health care is problematic for many reasons as well, namely that it is literally life and death, therefore inviting all kinds of state-based interventions and subsidies. Letting people suffer miserably and die on the doorstep of a hospital doesn’t really go over well with TV viewers. While some illnesses might be avoided or mitigated by good lifestyle choices, the link at the individual level is not strong enough to demand all individuals bear the blame of bad health. Add to that the difference in quality of care between rich and poor, and you quickly reach the conclusion that market-based health care is a pipe dream, no matter how efficient it might be.
Feb 27 2023 at 3:17pm
Daniel, you say that health care is a matter of life and death. I actually want to challenge that assertion. Two points:
As Kevin suggests in the post, most health spending is not to prevent immediate death or disability. Most people prescribed cholesterol-lowering drugs would not, in fact, die of cardiovascular disease if they didn’t. Most people who get the flu vaccine would not have died without it. Most people who take antidepressants will not kill themselves or be totally disabled by depression if they go off them. Most people who get colonscopies and mammograms would never have died from those cancers. I could list many, many more examples, but you get the point.
A lot of medicine is intended to modsetly lower the risk of death or make life more pleasant over time. It often fails to do this, but that’s beside the point. It’s a worthy goal, but I don’t it creates a strong obligation to pay for it using insurance. There are many things that aren’t part of medicine but which also reduce risk of death or make life better. Warm clothes, a nice house, reliable transportation, good food, job-relevant training. But there shouldn’t be univeral government provision of all these things. Give government money to the poor if you want, but there’s no need to select for them which of the myriad useful goods and services they should have.
You’re creating a false dichotomy. The situation is generally not “either we fully subsidize health care for the poor or they bleed out in the streets.” For most medical problems, there are multiple solutions, some expensive, some relatively cheap, and some practically free. Almost everyone has some ability to pay. I say let the rich folks drive Teslas and Cadillacs and use the lastest on-patient diabetes and hypertension medication, while those of us with more modest means can drive used Corollas and take older cheaper generics. In fact, expensive cars are only slightly better than cheap ones at transporting you. Likewise, the expensive drugs and procedures are often not much more effective than the cheap ones. If we had a market system, a ton of people would be free to save loads of money on health care, just like they do now on cars.
Feb 27 2023 at 3:19pm
For some reason my original formatting was not preserved. My first point begins with “As Kevin suggests” and my second with “You’re creating a false dichotomy.”
Feb 27 2023 at 5:59pm
I seem to get good affordable care by paying cash. Dentists. doctors, and pharmacists actually do like cash on the barrelhead instead of the insurance chase and hassle.
The house we are about to build is reinforced concrete foundation, walls, and roof. On a sandy hill in Florida. Building for cash (1/1– 620 sq ft) and only intend to get liability insurance. Fireproof, designed for F5 tornado, and well above flood zones don’t see the need to subsidize the beach front.
Feb 27 2023 at 6:29pm
Kevin said; “Health insurance as it currently exists, also makes little sense when viewed through this lens. In a free market, we would expect health insurance to cover treatment for conditions that aren’t a matter of when, but a matter of if.”
I made that calculation fifty years ago. I reasoned insurance premia exceeded NPV of insurance payouts. Otherwise there is no reason to sell policies. At age thirty-one and in very good health the p(if) was such that I used what would have been insurance payments to purchase the S&P500. As I am a former competitive athlete; I continued to train, monitor my diet and abstained from alcohol and drugs. My portfolio grew at 10% compounded over that 50 year horizon. I never had to use it. Ten years ago, I became covered under my wife’s policy. Good thing. The “When” occurred three years ago when I had a total hip replacement. The Surgeon performing the procedure billed insurance $47,500 and settled at $23,000. I still could have covered the cost via self-insurance.
Thomas Lee Hutcheson
Feb 28 2023 at 7:19am
Excellent points about hazard insurance plus premiums should be set on a forward-looking basis, as predictable risks of flooding, hurricanes, wild fires, etc. change with the rising concentrations or CO2 in the atmosphere.
It i somewhat less relevant for health insurance as it is a vehicle to transfer income for a special kind of age-specific consumption
Grand Rapids Mike
Feb 28 2023 at 1:16pm
I am probably over ensured on a number of areas: car, house and health. On house, the insurance cost can be reduced by raising the deductible, which I have increased to cover the rising cost there. For car insurance when I was young went after the lowest car insurance I could find. However when kids started to drive added extra liability insurance.
Regarding health insurance, at age of 50 almost right after receiving medical approval for life term insurance policy, found out I had a block carotid artery, 80% with floating plaque. With all the health insurance, paid zero for operation and hospital cost. The operation came out fine, the extra insurance paid off. I have seen where people pay minimal for health insurance then complain about lack of the choice of available doctors.
I look at insurance as covering unforeseen events I am willing to pay for now. In health as one ages you know something will happen, so I think it is good to consider higher insurance to increase the choice of doctors. For house insurance it can be manage with deductibles.
Knut P. Heen
Mar 1 2023 at 7:58am
Great article! The big problem is that “free” insurance is always great. By “free”, I mean that you use political means to get someone else to pay for your insurance.
Mar 2 2023 at 10:47am
Your hurricane example is a poor one. You don’t insure for being in a hurricane, you insure for damage. I’ve been through several hurricanes and never had damage. There are plenty of people in hurricane prone areas that never have anything more significant than a roof replacement, which also can happen with straightline winds outside of hurricane areas, although that is typically on a roof that is already degraded. Of course a lot of the roof damage you see after hurricanes are also on older roofs, not new ones.
Even for flooding, where your point is much better, when you start talking about flooding sometimes in the next 100 years, that’s basically a matter of if for the homeowners, not when, because they’re unlikely to live in a home for 100 years (or 30 years). So that’s still an insurable event, even if the government has largely crowded out private insurance and subsidized the market. And the government is (very slowly) getting better about not insuring buildings that are guaranteed to flood in a reasonably short period of time, as participating communities cannot issue permits for finished space at base flood elevation for new construction or for existing construction if there has been 50% damage.
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