From the Peanut Gallery

In one of my first economics posts, I discussed the classic law of supply and demand. In this post I am going to comment on the effect of artificial limits on supply as a cause of higher prices.

Some limits on supply are natural; there are just so many (or is just so much) of the good or service in the world. gold and diamonds are naturally rare, therefore valuable.

But there are other limits on supply that are artificial, usually a a result of a limitation imposed by the government.

The government-imposed limitation may be directly intended to reduce supply, such as liquor licenses or taxicab medallions, which in themselves become valuable economic goods. Historically, agricultural prices have been supported by requiring a specific allotment to grow certain crops (such as tobacco) or actually paying some farmers not to grow certain crops.

Intellectual property protections, like copyrights and patents, are intended to encourage “science and the useful arts” by assuring the author or inventor a time-limited monopoly. Such limits do, and in part are intended, to result in higher prices than if such protections did not exist.

The limitations may be for another purpose, such as quality assurance; for example, professional licenses usually require particular educational achievements and/or passing a licensing exam. Even where the limit serves such a quality-assurance purpose, the particular requirements might be adjusted to serve a price support purpose.

Jay Bohn
August 12, 2021

My last two posts((Economics 111: Insurance Basics I – Types of Insurance and Economics 112: Insurance Basics II – Premiums and All That)) covered types of insurance, premiums, and risk. I will now discuss some features of the Affordable Care Act, a.k.a. Obamacare, in light of these concepts.

Health insurance is a form of casualty insurance originally created to mitigate the risk of the costs of hospitalization and major medical expenses. During World War II, when employers were legally prevented from raising wages to attract employees, they began to offer health insurance as a recruiting incentive, leading to the situation today when employer-paid (or part paid) health insurance is a common, but not universal, fringe benefit.

Health insurance has grown, not just in the number of insured but in the scope of its benefits. It is no longer just for major expenses (although all medical expenses are now beyond what a typical patient could afford to pay out of pocket), but it covers office visits, physical examinations and prescriptions.

Another factor in the high cost of medical care is the legal obligation of hospitals to treat all comers, whether they can pay or not. Some of this “charity care” is reimbursed through government programs (that may simply shift the costs somewhat from urban hospitals primarily serving the poor to other hospitals fortunate to have a greater proportion of insured patients), but I expect that a great deal is paid by the insurance companies covering insured patients in the form of higher prices.

There are three basic cornerstones of the Affordable Care Act.

One is community rating, which greatly limits the ability of the insurance company to set premiums based upon a fine degree of precision risk calculation. This means that better risks (the young) will often pay higher premiums so that higher-risk customers (the old) can pay less.((I say “pay” although in many if not most cases the premiums are paid, at least in part, by the employer or the government.))

A second is the requirement that insurance companies pay benefits for pre-existing conditions. One particular risk the uninsured used to face were policy terms that denied coverage for pre-existing conditions. Just as you cannot retroactively buy car insurance after an accident, once you had a particular health condition, you could not get coverage for it. That would be like making a bet on roulette after the ball has stopped. This feature is very popular.

The third building block was intended to keep those disadvantaged by community rating in the insurance market, especially as the requirement for coverage of pre-existing conditions would eliminate that risk for being voluntarily uninsured. An insurance company cannot long pay out in benefits more than it takes in in premiums. Even people fortunate enough to have partially paid insurance as a job benefit may find that their share is more than they can afford. Some of these people may conclude, accurately or not, that the cost of the premiums is higher than the risk of being uninsured. These people are likely to be younger and believe that they can enter the insurance market when they are more likely to need healthcare. Younger people are typically better risks for health insurance companies, and so their premiums are lower. Older people become terrible risks, and if their premiums are commensurate with the risk, they become astronomical. (Remember, insurance is a bet and everyone wants to win.) To keep these people in the premium-paying pool so that they subsidize the higher-risk insured, the Affordable Care Act includes an individual mandate which requires them to have health insurance and imposes a tax penalty if they do not. The individual mandate was decidedly unpopular.((The two existential challenges to the Affordable Care Act to reach the Supreme Court, National Federation of Independent Business v. Sebelius, 567 U. S. 519, 530 (2012), and California v. Texas, ___ U.S. ___ (2021), involved the individual mandate.)) While it is still part of the Affordable Care Act, the penalty amount was reduced to $0.((See Tax Cuts and Jobs Act of 2017, Pub. L. 115–97, §11081, 131 Stat. 2092 (codified in 26 U. S. C. §5000A(c)).))

Jay Bohn
August 9, 2021

In my last post I discussed various types of insurance and likened the decision to buy insurance to placing a bet with the insurance company as a sort of casino. Just like a casino must balance the odds to assure its profitability, an insurance company must understand the likely cost of each risk in terms of the benefits it will have to pay and set its premiums accordingly, not too little that it goes out of business but not too much that it gets no business.

There is a perception that insurance companies have a lot of money, and this may well be true. Most of them are businesses with stockholders, and after payment of benefits, operating costs, and taxes have to make a profit to survive. While meaningful price comparison may be difficult, they do compete with other insurance companies and to some extent business will flow to the insurance company offering the coverage that customers are convinced they want for the lowest price.((What coverage is actually needed can be a far different question and one well beyond not only this post but any that I currently contemplate.))

There are other tools that insurance companies can use to control their risks. For many types of insurance the insured is responsible for a “deductible,” usually a fixed dollar amount of each claim (or aggregate of claims for the policy period) and/or a “co-payment,” whereby the insurance company will only pay a specified percentage of a covered loss.((Because higher deductibles and co-payments should mean lower premiums, they are also a way that the insured can fine tune the balance between costs and coverage to match her own risk tolerance.)) An insurance company can also obtain its own insurance policy for part of its risk; this is called “re-insurance.”((As some policy holders of the failed Mutual Benefit Company learned, reinsurance policies benefit the company (and its policy holders generally when it is insolvent) and not the holders of any of the polices that are reinsured.))

Insurance is also a highly regulated industry, and the government will often require policies to provide a certain level of benefits. Such requirements will likely either increase the premium or lead the insurance company to reduce benefits elsewhere. Although such requirements do certainly limit consumer choice, the insurance company can take them into account when setting its premium rates. Sometimes, however (always in the public interest, of course), the regulator will mandate the payment of benefits beyond those for which the policy provides during a policy term. I believe that health insurance companies were required to provide extra benefits in connection with COVID-19 and following Hurricane Sandy New Jersey prohibited insurance companies from charging a higher “hurricane” deductible for which their policies provided.

Insurance companies rely upon actuaries to calculate the risk of various perils in order to determine the appropriate premium. Changes in the regulatory environment during the term of a policy can lead to a situation where the risk in increased beyond that which had been computed and therefore the premiums (which the insurance company cannot change during the policy period) are insufficient to the risk, impairing the insurance company’s financial position to a greater or lesser extent. Every dollar in increased benefits requires an offsetting dollar of reduced expense or increased revenue somewhere.

The pricing of premiums relies upon the ability to predict accurately the expected payout for the aggregate of the risk the insurance company assumes. Actuaries may determine what characteristics of an insured make a particular peril more or less likely to occur, or more or less expensive if it does, but they do not, at least generally, predict risk at the policy holder level. The risk of a payout on a health insurance policy is, on average, less with a younger insured than an older. An insurance company that ignored the actual risk in order to price health insurance premiums lower for older policy holders would end up charging younger policy holders more than their actuarial fair share and lose them to a competitor. Such a company would likely attract a greater share of older policy holders.

While some knowledge of the risk being transferred is essential to the basic idea of insurance, too much knowledge is fatal to it. If the insurance company had a crystal ball that enabled it to predict accurately the cost in terms of benefits to be paid for each of its customer, it could more accurately price its premiums. But, because the premium is pretty much equal to the risk assumed, there is no risk transferred and the reason for insurance in the first place is would be obviated.

What automobile insurance customer would not increase coverage and/or reduce his deductible if he could do so retroactively after an accident? If you did not have health insurance and learned that you had a condition whose treatment was likely to be quite expensive, wouldn’t that change your cost-benefit analysis of whether to obtain insurance?((Stick a pin in this; I plan to discuss the feature of the Affordable Care Act that mandates coverage for preexisting conditions in the next post.))

Jay Bohn
August 5, 2021

In this post I will describe some basic concepts behind insurance. This discussion is a building block for other, more meaty posts that should be coming soon.

The basic concept of insurance is the spreading (perhaps a better word is “exchange”) of risk. Bad things happen in our lives, some thankfully relatively rare (like a sinkhole swallowing your house) others certain (death, as the most obvious example). Insurance is a contract whereby the insurer (which I will call the “insurance company” hereafter) agrees to pay to or for the beneficiary (or loss-payee depending on the type of insurance) a defined monetary benefit in the event that the specified bad thing (often called a “peril”) happens within the policy period. The insurer undertakes the risk of having to pay the benefit in exchange for the payment (usually by the insured) of the premium. From the insured’s point of view, the insured is assuming the certain loss of the premium in exchange for the right to the policy benefit if and when the peril occurs. Insurance can be seen as a bet between the insured and the insurance company, which acts as a sort of casino.

The insurance company has income from both policy premiums and its ability to invest its reserves between the time the premium is paid and the time it actually has to pay the benefit. The insurance company will pay not only the policy benefits, but also its own operating costs and possibly taxes and dividends to its investors.

There are several types of insurance. The types and policies can be very sophisticated and I am only discussing basics here.

Life insurance pays a death benefit if the insured dies within the policy period. A common type of life insurance policy is described as a “whole life” policy. Under such a policy premiums will be paid for the insured’s whole life (or a substantial part of it); so as long as the premiums are paid, the death benefit will eventually be paid. The premium will be lower the younger the insured is at the time the policy is issued because the expected life span (and premium-paying and investment periods) is/are longer. The insurance company wins the bet by the insured’s living longer, while the insured “wins” by dying sooner.

Another type of life insurance is the term policy. The policy will only pay a death benefit if the insured dies within the specified term. Premiums are likely to be lower than for a whole life policy for an insured of the same age and health because the insured may “lose” by outliving the policy term.

Another common type of insurance is casualty insurance. The casualty insurance policy pays if the insured property is damaged, such as a dwelling’s being destroyed by fire. Other examples of casualty insurance are flood insurance and title insurance.

A third type of insurance is liability insurance. A liability insurance policy has two significant benefits: it will provide a defense to a lawsuit asserting a covered claim and will also pay (up to the policy limit) if the insured is legally adjudged liable for damages resulting from such a claim.((The insurance company will almost always have the right to control the defense and to negotiate a settlement, but the insured’s consent to a settlement may be required.))

Some insurance policies, such as automobile insurance, will combine aspects of more than one of these types. An automobile policy will typically provide liability protection for claims by third parties in an accident and also pay for damage to the insured’s own car arising from such a casualty.

Health insurance may have evolved into a fourth type. The classic hospitalization/major medical policies that used to be advertised in the Sunday supplements 50 years ago that paid benefits of $50 to $100 a day were casualty policies insuring against the need to pay large medical bills. Now, however, health insurance polices provide coverage for routine doctor visits, medical tests, vaccinations, and periodic physical examinations. The payout is more certain, so the premiums are higher.

My next post will discuss insurance premiums in more detail.

Jay Bohn
August 2, 2021