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Self-Promotion: Pro and Con on the Individual Healthcare Mandate

By Tom W. Bell and Glen Whitman

I was featured in Monday's L.A. Times "pro and con" article on the individual healthcare mandate. Here's a key bit:

The point of the individual mandate is to balance the risk pool, but that's not really what insurance is supposed to do. With car insurance, the idea is not that you want good drivers to pay for accidents caused by bad drivers. Instead, you want there to be pools of people with similar risk: bad drivers and good drivers who pay different premiums.

I notice that a couple of commenters have taken issue with this argument, essentially saying "OF COURSE insurance is supposed to balance risk!" They're mistaken. But this is a point worth dwelling on, because it's easy to get confused.

Everyone knows that insurance does "balance risk" in a certain sense. It transfers wealth from those who have been fortunate (e.g., didn't get in a car accident, didn't have a house fire) to those less fortunate (e.g., did get in a car accident, did have a house fire). The premiums paid by everyone get paid out to a small group ex post. But ex ante, every policyholder could have experienced either outcome. To make this worthwhile for all buyers, they have to be pooled with other buyers who have similar risk. Otherwise, some buyers will find that it's just not worth it: their risk is too low to justify the high premiums.

This is very different from trying to "balance risk" in the sense of balancing low-risk policyholders with high-risk policyholders and charging them similar premiums. This approach creates a cross-subsidy from some policyholders to others ex ante. That is, even before we know which people will experience an unfortunate outcome, some policyholders are getting a much better deal than others. That's why some buyers drop out of the insurance pool -- because they're getting a lousy deal. Hence the demand for the individual mandate: it's needed to rope in the people who would rather opt out.

As a matter of terminology, the former should be called "risk pooling" and the latter "risk balancing"; using the same term for both just creates confusion. And as a matter of historical and economic fact, the insurance business arose primarily to do risk pooling. The idea that insurance should engage in risk-balancing is almost exclusive to healthcare, and it's assuredly the result of decades of government efforts to force insurance to accomplish policy goals that were no part of its origin.

Full post as published by Agoraphilia on February 17, 2010 (boomark / email).