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Sunday, November 04, 2012

Why Buy Insurance, Anyway?

Of the many criticisms I thought I might receive in response to my last post about the link between health insurance and job creation, I didn't expect to receive the primary criticism that I did: that buying insurance -- of any kind -- is simply a fool's errand. Jimbino makes the point in comments, and despite the somewhat "trollish" nature of the comments, there are enough good points in there that I started a reply. The reply grew so long that it became a new post.

Long story short, Jimbino points out that on average, people in the aggregate only get back 60% of their insurance premiums (and most never get anything). I have no idea if that's true, but it sounds reasonable enough.  They would never tolerate such odds at the casino (though people, for some reason, seem to think that 98% payout slots are a good deal). My gut, unsupported by empirical evidence, is that most people who think this way have no dependents and have never suffered a catastrophic event outside of their control. Indeed, Jimbino notes how insurance helps aging widows and hypochondriacs at the expense of young, healthy black men. Jimbino also asks about all the suckers in Illinois who pay for insurance but never get hit by hurricanes (apparently Jimbino has not heard of fire). There is at least a kernel of truth here, but only a kernel, since insurance is priced higher for those more likely to use it. Insurance costs more in New York and Florida than in Illinois, I suspect. If it doesn't there is a problem with the market. 

Here are some more general thoughts on why one might (or might not) buy insurance, after the jump.

It is true that insurance payouts are less than intake. They would have to be, or no one would do it, at least privately. It's why you see large entities self-insuring. Indeed, it's why my own firm self-insured all but catastrophic health events. My current employer self-insures dental insurance - the expenses are much more calculable and catastrophes are rare.  It is just cheaper to self insure sometimes. Of course, a way to improve the payouts is to make such insurance public, so that payouts equal all but the expenses of running the system.

Even though insurance usually winds up being a net negative, I'm not so sure that going without and self insuring works for three reasons:

1. Self insurance takes financial planning that most families cannot achieve in practice. An automatic payroll deduction makes health insurance happen. A mortgage escrow makes property insurance happen. With self insurance, you can't bank on families saving that same money for a rainy day. Indeed, think of all the people who let their auto insurance lapse. If you don't "force" it through an automatic deduction of some sort, it just won't happen as a practical matter, even though it should. This is tied to the same irrationality that causes people to buy insurance in the first place rather than simply save, I suppose, but there you have it. 

2. Self insurance requires liquidity and credit. Most people don't have cash in the bank for catastrophic illness or home destruction. So they have to borrow. Is it more rational to wait until the illness or destruction, and then borrow? Sure, I suppose, but only if you can borrow the money when you need it, and only if you can pay it back. If the primary wage earner is the one struck with health, disability, or life (death!) issues, forget that loan. Even if credit is available, a $100 a month home insurance premium may be thrown away if nothing happens, but the $1000 a month on a second mortgage sure will be painful if you house burns down. Of course, maybe you'll never have to pay it, but Jimbino significantly discounts risk aversion. Some would rather pay $100 a month now, than risk paying $1000 a month later.

 In a similar vein, I've added up all the money I expect to have wasted on life insurance when it runs out and I'm still alive. It's no small amount. It's worth every penny knowing that my wife, who's been out of the job market for years so she can spend time at home with the kids, won't have any trouble paying the bills if I get hit by a bus.  Jimbino says that, like work, nobody wishes they had more insurance on their deathbed. This may be true for him/her, but I would certainly be concerned if I were dying and uninsured. My first major purchase when she first got pregnant? A new car. My second major purchase? Life insurance.  A scam by the insurance company? Maybe so, but I'll sleep just fine tonight.

 3. The bargaining/shopping power of insurance is important. My $150,000+ bill was negotiated down to $35K by the insurance company. Why? If the hospital doesn't agree, the insurer will send folks to other hospitals. Could I have negotiated it down? Maybe, maybe not. Could I have gone to Mexico or Czech Republic and paid less, as Jimbino suggests? Actually, no. Turns out that the expert in my issue (afflicting 60 people or so in the last 20 years) is here at Penn, half an hour away. Boy did I get lucky. People come from around the country to see him. And they take the train, because you aren't supposed to fly with what I had. So there's no shopping around in some cases, and it's not about being a hypochondriac.

Even for more run of the mill stuff, is it really an answer to say, "Well, you could get this cheaper, if you fly to Brazil." Really? Perhaps some of that percentage that the insurance company gets to keep is worth not having to fly my autistic kid to Brazil to see a developmental pediatrician - and borrow to pay for it, as well.

Perhaps I've given Jimbino too much credit by giving the self insurance point too much credit. I don't think so, though. Jimbino's views suffer from a common economic misconception - that because something makes economic sense in some circumstances and for some people, it must obviously work for everyone, all the time. I want to make clear that self insurance really does make sense, but in very narrow circumstances. For others, high deductible catastrophic insurance might be the way to go. But not for everyone, and not just for hypochondriacs.

Posted by Michael Risch on November 4, 2012 at 06:11 PM | Permalink

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I thought the primary argument in favor of insurance was the diminishing marginal utility of money, as BDG notes in his comment in the earlier thread. The basic explanation, from Steven Croley & Jon Hanson, The Nonpecuniary Costs of Accidents: Pain and Suffering Damages in Tort Law, 108 Harv. L. Rev. 1785, 1794 (1995):

************
The reason that individuals prefer certain but small losses to uncertain but greater losses, even when the expected loss is the same in both cases, has to do with the economic principle of the diminishing marginal utility of money. That principle holds that, in general, the marginal utility a person derives from her first dollar is greater than the marginal utility the person derives from her second dollar. Put slightly differently, the purchases an individual makes with her first thousand dollars bring greater satisfaction than the purchases she makes with her second thousand dollars. This makes intuitive sense; otherwise she would have made the second set of purchases first.
. . .
One consequence of the diminishing marginal utility of money is risk aversion toward economic losses. Because an individual gets less satisfaction from the next unit of a given economic resource than from the last, the individual would forego acquiring that next unit of the resource to avoid the risk of sacrificing the last. Risk-averse consumers will prefer a certain return to an uncertain return of the same expected value and, hence, will be willing to pay more than the expected value of a loss to avoid the uncertain risk of it actually occurring.
Insurance satisfies that preference. By purchasing insurance, consumers transfer pre-accident income to post-accident endowments until the marginal utility of the last dollar transferred in the pre-accident world equals the marginal utility of that dollar in the post-accident world. A consumer's goal when purchasing insurance is, thus, to equalize marginal utilities of income over time and over possible states of the world. In this way, consumers maximize their expected utility of income.
*********

Posted by: Orin Kerr | Nov 4, 2012 6:59:15 PM

I think that's right, Orin. I do mention risk aversion above, and I think the marginal utility is associated with liquidity and credit. After all, if I were a repeat player and believed I would come out ahead in the end, the marginal utility of spending zero dollars is better than the marginal utility of spending 100 dollars, and I can even earn some return on the saved money -- but only if I expect to come out ahead in the long run, and I can only do that if I have funds to pay off my debts.

So, there has to be more to it than just diminishing marginal utility, or else we would never see self insurance or high deductible health insurance, and we do.

Posted by: Michael Risch | Nov 4, 2012 7:10:11 PM

I'm perplexed by this discussion. Is the point to speculate about things that are well and uncontroversially understood? The economic analysis of insurance, which does not require an acceptance of Chicago school dogmas to be explanatory, far predates a 1995 Harvard Law Review article. The topic was comprehensively treated by the 1970s. As BDG said, it transfers money from states of the world in which it is less needed (and thus less valuable) to those in which it is more needed (and thus more valuable).

People are willing to pay for that service, but not to pay an unlimited amount for it. Rational people tend to insure against catastrophic losses but not noncatastrophic ones. The difference between the two cases is that money is not relatively more valuable enough, in the latter case, to justify the loss in expected dollars from administrative expenses. You would never expect to see high-deductible health-insurance (or self-insurance) if health insurance were free or had no administrative costs. Because it does, the pattern you identify reflects the tradeoff between costs and benefits.

That is not to say that everyone is rational, but simple rationality goes far toward explaining existing insurance practices, Jimbino's confusing rants to the contrary notwithstanding. His comments would have been better ignored.

Posted by: anon | Nov 4, 2012 7:31:26 PM

I'm perplexed by this discussion. Is the point to speculate about things that are well and uncontroversially understood? The economic analysis of insurance, which does not require an acceptance of Chicago school dogmas to be explanatory, far predates a 1995 Harvard Law Review article. The topic was comprehensively treated by the 1970s. As BDG said, it transfers money from states of the world in which it is less needed (and thus less valuable) to those in which it is more needed (and thus more valuable).

People are willing to pay for that service, but not to pay an unlimited amount for it. Rational people tend to insure against catastrophic losses but not noncatastrophic ones. The difference between the two cases is that money is not relatively more valuable enough, in the latter case, to justify the loss in expected dollars from administrative expenses. You would never expect to see high-deductible health-insurance (or self-insurance) if health insurance were free or had no administrative costs. Because it does, the pattern you identify reflects the tradeoff between costs and benefits.

That is not to say that everyone is rational, but simple rationality goes far toward explaining existing insurance practices, Jimbino's confusing rants to the contrary notwithstanding. His comments would have been better ignored.

Posted by: anon | Nov 4, 2012 7:31:32 PM

Jimbino the Troll responds:

I preface my response, first, by noting that a “troll,” in internet lingo, is a person who posts comments that are off-topic, inflammatory or intended to elicit emotional response. My earlier comment was clearly not off-topic, since it was considered serious enough to warrant the OP’s continues attention. As far as inflammatory or intended to elicit emotional response, I merely point to my teachers Jesus Christ and Thomas Paine, the first of whom overturned money-changer tables in the temple and called the Pharisees “a generation of vipers,” and the second of whom was nothing if not inflammatory in Common Sense and The Age of Reason. He was the far-away best-selling author of his time, a position none of you, including Orin Kerr, will ever achieve.

Secondly, you all argue like utilitarian socialists who have no concern whatsoever with the liberty rights of those who don’t buy into your Insurance Religion. Even if your utilitarian analysis were correct, it would not justify the rights invasion that insurance in general, and Obamacare in particular, represents. Speaking of health insurance here, can you conceive of the possibility that there are lots of folks out here, like the Amish, Jehovah’s Witnesses, Christian Scientists, Homeopaths and me, who can’t or won’t buy into your Insurance Religion? Not to mention Jesus of Matthew 6 who famously said:

Matthew 6:31 “Therefore do not worry, saying, ‘What shall we eat?’ or ‘What shall we drink?’ or ‘What shall we wear?’ 32 For after all these things the Gentiles seek. For your heavenly Father knows that you need all these things. 33 But seek first the kingdom of God and His righteousness, and all these things shall be added to you. 34 Therefore do not worry about tomorrow, for tomorrow will worry about its own things. Sufficient for the day is its own trouble.

Moving on to the meat of the discussion:
"Long story short, Jimbino points out that on average, people in the aggregate only get back 60% of their insurance premiums (and most never get anything). I have no idea if that's true, but it sounds reasonable enough. They would never tolerate such odds at the casino (though people, for some reason, seem to think that 98% payout slots are a good deal). My gut, unsupported by empirical evidence, is that most people who think this way have no dependents and have never suffered a catastrophic event outside of their control."

Quite right. And why do you not know what return you’re getting on insurance? Because insurance companies and the medical establishment spend a great part of your premium dollar hiding the ball. I had to file an FOIA request to get the Medicare allowances per CPT code here in Texas, for chrissake. Armed with that information, I invited the hospital and docs, under threat of litigation on behalf of two friends, to write off over $2000 in ER charges. They complied, probably because they didn’t relish the thought of having the strong light of legal discovery illuminate their hidden disgusting and discriminatory billing practices.

"Indeed, Jimbino notes how insurance helps aging widows and hypochondriacs at the expense of young, healthy black men. Jimbino also asks about all the suckers in Illinois who pay for insurance but never get hit by hurricanes (apparently Jimbino has not heard of fire). There is at least a kernel of truth here, but only a kernel, since insurance is priced higher for those more likely to use it. Insurance costs more in New York and Florida than in Illinois, I suspect. If it doesn't there is a problem with the market."

Wrong. Peoria was my metaphor for the skewed evidentiary problem in which National Proletarian Radio and others, like you, lament lack of insurance coverage after a disaster, with no mention whatsoever of the billions wasted in premiums warding off non-disasters. Ha!—I imagine NPR’s news reports couldn’t be less interesting if they did cover non-events in Peoria. I am a proud Chicagoan (U of C) and I don’t consider Illinoisans suckers, except as evidenced by their choice of governors and mayors. Furthermore, some insurance, like SS, covers indolent spouses of non-workers and bears almost no relation to the actuarial pricing you refer to.

"I'm not so sure that going without and self insuring works for three reasons:
1. Self insurance takes financial planning that most families cannot achieve in practice. An automatic payroll deduction makes health insurance happen. A mortgage escrow makes property insurance happen. With self insurance, you can't bank on families saving that same money for a rainy day. Indeed, think of all the people who let their auto insurance lapse. If you don't "force" it through an automatic deduction of some sort, it just won't happen as a practical matter, even though it should."

Wrong again. Your argument would justify forcing the gummint idea of good sex and food, not to mention cars, TVs and religion on all us idiot Amerikans too dumb to figure it out for ourselves. Furthermore, when you speak of auto insurance, you are referring to the possibly justifiable liability insurance that covers injury to others, which is wholly different from life, fire, health, flood, title, homeowner’s and other types that do not involve injury to others.

"2. Self insurance requires liquidity and credit. Most people don't have cash in the bank for catastrophic illness or home destruction."

Right on! Do you know why “most people” don’t have the funds to cover the needs of their family? Clue: they are taxed and insured to death by the nanny state. Admit it: nobody in the Bible and in most of the world today and throughout history has subscribed to an insurance system at all—certainly not one that impoverishes families to the point that they can’t keep food on the table or find their kids a good school. Furthermore, the last thing a person like Jesus, Jefferson, Ford, Edison, Carnegie, the Wrights, Gates, Dell, Jobs/Wosniak and Zuckerberg thinks of when pledging their Lives, Fortunes and Sacred Honor or setting out to change the world is insurance! They often forgo the baggage of family and breeding in order to fund their risky enterprises. In your perfect world, we’d all have fully insured and safe big families but miss out on cars, computers, TVs, cell phones, airplanes and steel! Forget the lost opportunity! In my perfect world, cowards like Jesse Jackson Jr and you would be squished along with Ayn Rand’s villains.

"In a similar vein, I've added up all the money I expect to have wasted on life insurance when it runs out and I'm still alive. It's no small amount. It's worth every penny knowing that my wife, who's been out of the job market for years so she can spend time at home with the kids, won't have any trouble paying the bills if I get hit by a bus. Jimbino says that, like work, nobody wishes they had more insurance on their deathbed. This may be true for him/her, but I would certainly be concerned if I were dying and uninsured. My first major purchase when she first got pregnant? A new car. My second major purchase? Life insurance. A scam by the insurance company? Maybe so, but I'll sleep just fine tonight."

The question is: do you sleep fine at night supporting a system that forces your breeding and insurance philosophy on everyone else, as Obamacare does? All I can say is, you, like Marie Antoinette, Mussolini, Ceausescu and the Romanovs, who also slept well at night, are not aware of the threat represented by oppressed folks in armed rebellion.

"The bargaining/shopping power of insurance is important. My $150,000+ bill was negotiated down to $35K by the insurance company. Why? If the hospital doesn't agree, the insurer will send folks to other hospitals. Could I have negotiated it down? Maybe, maybe not. Could I have gone to Mexico or Czech Republic and paid less, as Jimbino suggests? Actually, no. Turns out that the expert in my issue (afflicting 60 people or so in the last 20 years) is here at Penn, half an hour away. Boy did I get lucky. People come from around the country to see him. And they take the train, because you aren't supposed to fly with what I had. So there's no shopping around in some cases, and it's not about being a hypochondriac.

Even for more run of the mill stuff, is it really an answer to say, "Well, you could get this cheaper, if you fly to Brazil." Really? Perhaps some of that percentage that the insurance company gets to keep is worth not having to fly my autistic kid to Brazil to see a developmental pediatrician - and borrow to pay for it, as well."

OK, go on cloaking yourself in the pride of your privileged White treatment in clinics and by docs. I’m so glad you and your kids don’t have to be treated in the lousy clinics and public schools in our ‘hoods. We know that if our kid needs 3 tabs of Mebendazole, we can either pay to see a doc and get a prescription, then pay through the nose for three tabs at Walgreen’s, or we can simply cross the border at Laredo and get 3 tabs over the counter for $2. Your ivory tower continues to blind you to reality, as theirs did in the sad case of the Cambodian intellectuals.

"I've given Jimbino too much credit by giving the self insurance point too much credit. I don't think so, though. Jimbino's views suffer from a common economic misconception - that because something makes economic sense in some circumstances and for some people, it must obviously work for everyone, all the time. I want to make clear that self insurance really does make sense, but in very narrow circumstances. For others, high deductible catastrophic insurance might be the way to go. But not for everyone, and not just for hypochondriacs."

Apart from the impossibility of giving my argument “too much credit,” you confuse me with somebody who would force my religion on everybody else. No, you miss the point altogether: it is you and Obama who are forcing your Insurance Religion on everybody. I do not wish to control the lives of others and I ask for nothing more than to be left alone by the Nanny State, the RC Church, and all the other socialists who are trying to force their religion on me.

Posted by: Jimbino | Nov 4, 2012 10:18:28 PM

Michael, I think what everyone is reacting to is that, although you do mention risk aversion (precisely once), you skip right by it. The diminishing marginal utility/risk aversion point is fundamental, and it is different from how most people will understand your point about liquidity and credit. Whether buying insurance makes sense has very little to do with whether one has liquidity and credit as such--I (and I suspect you) have sufficient liquidity and credit to absorb the total destruction of my car; but I still buy collision insurance. The reason to buy insurance is not that I can't pay the $30k for a new car; it is only that it is more painful to pay $30k all at once (even adjusted for the low probability) than it is to pay $300 a year.

Now, it is true that you mention all this. But the reason you are getting pushback is that at other places you ignore all this, e.g. by accepting the laughable casino analogy (which necessarily ignores risk aversion); talking about the "suckers" in Illinois; accepting, at least as a theoretical matter (mitigated only by practical limits such as money in the bank account) self-insurance as the ideal and dismissing life insurance as a "scam", etc. The risk aversion point shows why all of these statements are not just wrong, but outrageously wrong.

In short, there is no kernel there, and it is most unfortunate that you present it as if there were.

Posted by: TJ | Nov 4, 2012 10:55:15 PM

Right, TJ,

Michael's posts are rambling, diffuse, uncertain and confused, probably due to the fact that he is slowly gaining clues as to the foolishness of insurance and his own arguments in its defense.

Your response that involves utilitarian "diminishing marginal utility" analysis is totally beside the point. If we were in a courtroom, I'd agree to stipulate the validity of your argument, since it has nothing whatsoever to do with the liberty question of a person's imposing his particular idea of risk-aversion or other superstition on me and other folks.

I have my own ideas of the value of life vs liberty, risk vs security, breeding vs climbing Everest, and I consider it a call to arms when somebody like Obama, the Pope or Michael proposes forcing me to adopt his Religion, whether it involve the Immaculate Conception or the Insurance Abortion.

Posted by: Jimbino | Nov 4, 2012 11:25:30 PM

Jimbino, in your attempt to be provocative, you are being analytically incoherent. Your problem does not appear to be with insurance, but with the mandate to participate in risk pooling that comes with the Affordable Care Act. We understand: you don't like the "gummint." There is, however, nothing new to your critique of the ACA, and that critique has almost nothing to do with the administration of insurance in general.

If you are claiming to think that health insurances helps nobody who is poor or Black, then you are either ignorant of the relevant empirics or are being disingenuous. I very strongly suspect the latter, which is what has led to your being called a "troll." Your rants are best ignored, but because others seem to be paying attention to you, it is worth mentioning your analytical incoherence.

Posted by: anon | Nov 5, 2012 12:22:34 AM

Quite right, anon,

I am being "provocative," which has long been one of the qualifications for admission to the U of Chicago. However, I have more than one "problem," as you put it:

In my role as a victim of Obamacare, I decry the compulsion that interferes with my liberty. In my role as a scientist and teacher, I am forced to point out stupidity wherever it rears its ugly head and in whatever form.

Yes, on net, Social Security insurance harms the poor, working Black male and redistributes his wealth to the indolent well-off White widow. Are you dense enough to need proof of that simple fact?

While there may be nothing "new" in my critique of the ACA, there does seem to be a glaring deficiency in the thinking of those who support insurance on both moral and utilitarian grounds. It should be obvious, even to you, that Martin and others in the Ivory Tower are foundering in ignorance regarding not only risk-benefit analysis, but also regarding simple facts about who pays how much for what insurance and how insurance harms the least among us and how it is used as a vehicle to enrich a few and redistribute wealth from the poor to the rich, from the young to the old, from the Black to the White and from the male to the female.

Posted by: Jimbino | Nov 5, 2012 1:10:39 AM

Boy, it must be a slow news day if this offhand post is getting so much attention. Yes, TJ, you are right that I didn't lay out the full theory. I'm aware of the theory. Two failings in my post (among others, I'm sure): (a) I thought comments on the last post made the points (as Orin points out) and (b) I intended to discuss risk aversion v. risk seeking as well as utility related to losing something you have v. losing a bet. I should have mentioned both points.

What I wanted to do was focus on some of the practicalities that lead to the theory. Practicalities like limited rationality, even with risk neutrality and constant marginal returns. Practicalities like liquidity. Indeed, if I had enough money in the bank, I would NOT buy collision insurance. The $30K might be painful, but my risk profile changes the more money I have (as does my marginal utility), and if I expect to own many cars in my lifetime, then it might be more profitable not to buy collision insurance.

And also practicalities in bargaining power - some of that 40% insurance premium pays for a discount on my bill. And since I don't live on the border and can't hop down to Mexico for self diagnosed brain surgery, that discount is worth something.

I agree with anon that Jimbino is now incoherent. The best example: poor kids forced to go to inner city clinics. If those poor kids got insurance (and many could and do, even now, via S-CHIP), then they don't have to do that anymore. Chalk one up to insurance. So, I'm with anon - I wanted to make a point about when you might self-insure, but the interesting point may now be lost.

Posted by: Michael Risch | Nov 5, 2012 7:17:13 AM

Michael,

For your information, you may post a bond in the amount of minimum liability insurance (something like $65,000). Then you won't have to deal with a sleazoid auto insurance company ever again. Unless, of course, you want to throw you money away on Collision or Comprehensive coverage.

Posted by: Jimbino | Nov 5, 2012 2:47:07 PM

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