Introduction. This solution will outline a theory of insurance and demonstrate that the present practice of health insurance violates almost every tenet of that theory. Part I presents the theory; Part II explains the practice; Part III summarizes.

Part I. The standard business model of insurance companies is pooling of individual risks. Within the pool of those whose health is insured there occurs a redistribution of wealth, from those who remain healthy to those who become sick. (Just as with car insurance one is supposed never to want to use his insurance policy. The winners are reluctant to win.) However, the redistribution from the healthy “losers” to the sick “winners” is random and unpredictable for anyone, including the insurance company actuaries. There is no pattern to the redistribution. If the insurance losers could pinpoint the future insurance winners, then they would refuse to share risk with them and buy lower-premium insurance to pool risk with other losers. The pool of the insured is, from the point of view of risk, homogeneous: every person looks similar to any other person.

Events that can be insured are defined by the idea of “class probability.” “We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class,” writes Mises. Fortunately, even this knowledge is sufficient for an insurance company to make profits. So, winning insurance comes as a complete accident to the insured; it is an unpredictable event.

Uninsurable risks, on the other hand, are those that are affected by individual behavior. What depends upon individual initiative and responsibility cannot be insured. Hence it is impossible to insure oneself from, say, committing suicide or from taking business losses or from being unemployed, as all these are under one’s own control. For example, if you are insured against entrepreneurial errors, then you become mere manager, and the insurance company, the real owner of your company and entrepreneur risking the capital. Unfortunately, the modern health insurance does not for the most part deal with insurable risks, because the aspects of health it insures are very much dependent on the insured’s own conduct. As matters stand now, insurance encourages irresponsible behavior with regard to one’s own health and working efficiency; it helps to multiply, prolong, and worsen disease.

That’s why a distinction must be drawn between catastrophic illnesses which are mostly random and regular upkeep of health the extent of whose success or failure can often be predicted and which is to that extent nonrandom. This latter is uninsurable; moreover, insuring it generates moral hazard and is for that reason highly inefficient from society’s point of view. Routine medical care is best bought in the same way car maintenance is bought: fee for services rendered. Prices and quality will normally vary, offering something to everyone.

Part II. Interventionism in the insurance market began with forbidding insurance companies to discriminate between risks. Premiums shot up and lots of people dropped out, raising prices still further. If health insurance is now made compulsory for everyone, then there will be more freeloaders and more sickness against which insurance companies will not be allowed to discriminate and which is unlikely to be offset even by healthy people who would rather be without insurance and who are coerced into paying for it. Insurance will therefore become even more expensive. If the public demands that the government contain the costs, price controls will be imposed, and we will experience shortages of medical services. Politically correct diseases will get priority, while people with politically incorrect illnesses (such as smoking-related) will be shown the door. Professional medical “ethicists” will be working full-time deciding who “ought” to get treatment and who “ought not” to get it. It is, in my view, an uninviting prospect.

What is called private insurance in the US is actually prepaid consumption. Instead of insuring catastrophic illnesses, people are insured even for simple visits to the doctor. This is absurd. Routine health care is a commodity like any other; it should be paid for in cash.

Then there is employer-provided insurance. This is a holdover from World War II, during which price and wage controls were imposed by the government. This caused companies to compete for workers by offering non-wage tax-exempt incentives or “fringe benefits.” Health benefits were one of them. In reality, however, there is no reason why health insurance should be provided by employers, any more than shoes, butter, and movie tickets should be provided by them. It is immaterial to the business owner whether to attract workers with higher wages or “benefits.” If the practice of bundling insurance with salary were abolished, worker salaries would increase corresponding to the lower costs of doing business. Overall employee happiness would go up, as simple economic analysis demonstrates. And, of course, large companies would no longer be privileged over small businesses.

Consider also Medicare and Medicaid. These are little more than welfare payments. It would be more efficient to increase the welfare cash transfers and let the beneficiaries decide whether to spend the extra money on their health insurance or in any other way. (To be sure, the public would never allow that, all to the good.) From the beginning they also featured the perversities of cost-plus payments to hospitals, insurance premiums based on “community rating,” whereby every person in a some arbitrary geographic area regardless of age, habits, occupation, race, sex, etc. is charged the same price, and a pay-as-you-go system which causes premiums for everybody to go up in an unlucky year regardless of individual behavior. These caused costs to skyrocket and ultimately to destroy the cost-plus system. National health insurance may be the desperate though logical next step.

The blueprint for reform should now be apparent. In includes:

  1. Ending federal spending on Medicare and Medicaid.

  2. Eliminating all “anti-discrimination” regulations of the insurance industry.

  3. Encouraging tax-free Health Saving Accounts (HSA) to wean Americans from the practice of having third parties pay even for routine health maintenance. As part of that it is a good idea to repeal the requirement to have a high-deductible policy as a prerequisite to establishing an HSA. At the same time individuals should be allowed to use their HSA to make premiums payments for any high-deductible policy they choose to purchase.

  4. Providing all Americans with a (non-refundable) tax credit for 100% of health care expenses and making all medical expenses tax deductible. This will immediately make health care much cheaper for the majority of the population.

  5. Breaking the link between employment and insurance, between the size of a business and insurance; and restoring a market for individual health insurance polices via reforms 1-4.

Part III. Once again we see how one act of interventionism begets, according to economic logic, another. Insurance companies can barely deal with high-priced group insurance; offering individual insurance for routine health care and without the ability to discriminate would now cost them a fortune, and there will be few buyers. At the same time costs of health care for uninsured are higher than ever, thanks again to the predominance of third-party payers.

Now both socialism and pure free market are self-consistent systems, though socialized industries create islands of computational disorder, such that when the number of government-run enterprises reaches critical mass, the economy is plunged into chaos. A socialist country does not have an economy; its central planners operate in the dark, unaware of how their actions affect other human beings. Interventionism, the “third way,” on the other hand, is beset with contradictions. Given everything I’ve said so far, it is clear that the correct response to it is away from socialism, not towards it; it is to restore unhampered free market in health insurance.

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