A Spontaneous Order: Insurance
By RadCap
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In a free market society, insurance will likely play a central role in the operation of many services ranging from security, title dispute resolution, the alleviation of the devastating effects of natural disasters, and more. Unfortunately, many people are confused as to the nature and proper scope of insurable events due to massive interference and misinformation propagated by the State. This chapter will focus on the general nature of insurance, and its corresponding power and limitation in free markets. A natural starting point for this topic will be to examine the nature of insurance itself. Hans-Hermann Hoppe describes the incentives each person faces in an insurance pool:
Any insurance involves the pooling of individual risks. Under this arrangement, there are winners and losers. Some of the insured will receive more than they paid in premiums and some will pay more into the system than they ever get back. This is a form of income redistribution from the healthy to the sick, but the characteristic mark of insurance is that no one knows in advance who the winners and losers will be. They are distributed randomly or unpredictably, and the resulting income redistribution within a pool of insured people is unsystematic. If this were not the case — if it were possible to predict the net winners and losers — the insurance losers would not want to pool their risk with the insurance winners; they would seek to pool their risk with other “losers” at lower premiums.
… Now even if the insured themselves do not recognize that there are systematically predictable winners and losers, free competition in the insurance market would eliminate all systematic redistribution among the insured. In a free market, any insurance company that engaged in any systematic income redistribution (mixing people with objectively different types of risks into one single group) would be out-competed by any company that did not engage in this type of practice. Another insurance company might realize that there are people who sit behind desks and rarely fall off their chair and injure themselves. They would recognize that they could profitably offer a lower premium to desk jockeys and insure them in a separate pool from the professional athletes. And by offering lower premiums, they would of course lure away those people who had previously been mis-insured. As a result, the various companies that had mis-grouped people (by mixing their low-risk clients in the same pool with their high-risk clients) would have to raise the premiums for their higher-risk clients to their naturally higher level.[1]
“Winners” and “losers” in this context simply refers to those clients who received more (winners) or less (losers) in reimbursements than they paid into the system. This should not be confused with someone who comes down with cancer (which his insurance covers) as being a winner in the general sense of the term. Furthermore, when Hoppe references income redistribution from the “healthy” to the “sick,” he is referring to a redistribution of funds from those who didn’t experience the occurrence of a covered risk to those who did. This clarification may seem obvious. It is important, however, to make clear that the above description applies to all forms of insurance. The most efficient way to pool clients, given the goal of insurance is to bear risk, is by grouping together those who have like or homogeneous risks (at least to the extent of which may be objectively determined). If clients with different or heterogeneous risks were to be pooled together, then the less at-risk clients would be effectively subsidizing the more at-risk clients in the form of higher premiums. As a consequence, these lower at-risk clients would be incentivized to relieve themselves of this coverage in the pursuit of a company that charged premiums which corresponded more closely to the actual risk they present. Finally, for a risk to be “insurable” at all, one must be unable to predict with relative certainty those clients who will be “winners” or “losers” as defined above. If the winners or losers were able to be identified in such a way, then insurance companies would likely refuse to insure the would be “winners” and the would be “losers” would likewise refuse to purchase insurance.
A delicate balance is sought in the insurance industry, where the upper limit of what may be charged is tempered by the presence of other competitive industries willing to lower their premiums offered, and the lower limit is tempered by the desire to avoid negative cash flows, or losses. To more effectively determine optimal pricing at any given point in time, insurance firms will be compelled to engage in continual in-depth research regarding the field covered. Determining the premiums for natural disaster occurrence, for instance, will largely be based upon a given client’s geographical residence. In order to determine a price figure for this client, the insurance agency in question will have to invest in research that reveals the risk of such an event occurring in the proximity of the client’s residence. Naturally, those companies that attain more accurate data on such risks will be at a relative advantage to their competitors as such information will more precisely reveal the risk and frequency of its payouts to clients. This information will enable an insurance agency to ascertain the “lower limit” of what it is willing to charge its clients with greater precision.
The incentives mentioned above will drive these insurance companies to determine ever more refined groupings and sub-groupings for their clients. This process of discrimination will likely be based off of objectively verifiable criteria and not subjective bigoted prejudice – as the former will result in greater market share and profits and the latter in a loss of market share and losses. In other words, if a company uses poor data (or unverifiable prejudice) to determine prices, it will either overcharge for its services driving clients away to lower cost alternatives or undercharge relative to actual risks, resulting in losses, which will either cause the company to alter its practices or go broke, thereby freeing up the resources it once commanded to more efficient and profitable firms in the marketplace.
Risk and Uncertainty
Risk and uncertainty are categorically different phenomena. Risk refers to a chance occurrence in a knowable long-run probability distribution. Uncertainty refers to a chance occurrence in which no (or very little) information regarding probability is known. Mises introduces the terms “class probability” and “case probability” to refer to measuring the probability of repeatable events and unique events, respectively. Those events whose approximate likelihood can be known from repeated testing, such as the odds of a coin flip, can be mitigated by the use of insurance. The likelihood of one’s property catching fire can be predicted on the basis of long-run frequency distributions and thus, by acquiring insurance, one can defend himself from the consequence of a fire. It is only possible to determine risks for classes of people or events, but not for singular events or people. Mises affirms this point:
“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.”[2]
The danger presented to someone without insurance is quantifiable; the risk of one’s property catching fire in the future can be extrapolated from the whole set of past fires. Because the probability of one’s house catching fire is determinable, it is considered a member of “class probability.”
Conversely, those events whose probability cannot be determined by any past outcomes are uncertainties, and have no determinable probability of occurrence. Suppose Billy the Kid and Jesse James enter into a duel. In such a case, it would be impossible to determine the probability of a given outcome, as each of their prior duels would have involved a unique context and environment. For instance, their prior opponents may have had different skill sets, felt ill, carried a different fire arm, or maintained it differently. Perhaps the humidity was higher, the sun brighter; there may have been a distracting member in the audience, either The Kid or James may harbor emotional attitudes about each other, perhaps the landscape offers greater/lesser cover, etc. All of these contingencies affect the circumstances of the current duel, and it would thus not be an approximate replica of past duels. The outcome of a duel is uncertain, not risky. Risky implies knowledge of the probability of occurrence. Other uncertain events include the presidential election of 1944, the performance of individual athletes, the creation of art, the emergence of social movements and revolutions, entrepreneurial activities, and many more. These events have uncertain outcomes as they all occur within heterogeneous circumstances. These are not insurable events. The best way to prepare for such uncertainties is to accrue savings in the form of money. This is because money, in contrast to any other good, allows its holder to acquire the maximum amount of uncertain goods at uncertain times/locations in the future. Should one of our duelists take on injuries, it would be far easier for him to acquire medical care by paying the asking monetary price, as opposed to attempting to barter for it.
Events that fall within the category of “class probability” are those which are known to occur at relatively constant frequencies within a given set of parameters. An example of an event that falls into the category of class probability is coin flipping. The circumstances behind coin flips are approximately the same, and it has been demonstrated through repeated testing that the odds of a given coin falling on heads or tails is 50/50. In other words, because fair coin flips are nearly identical, one may extrapolate the probability of an outcome for a particular coin flip based on trends observed from the results of numerous past coin flips. Another example of a repeatable event is a lottery. One knows from the outset that there will be a lottery winner, however this knowledge does not reveal to him whom the particular winner will be. Thus, because it is known that there will be only one winner of a lottery (at least in this hypothetical), the likelihood that any one person may be the winner can be appraised and quantified based on the proportionate amount of tickets he purchases with the total number of tickets available. The ability to appraise and quantify the risk of such an event occurring, along with the inability to definitively determine who the particular winner will be, renders it viably insurable.
If it were possible to determine or predict the occurrence of a particular event with a high degree of certainty, then insurance would be unnecessary. Insurance is only valuable insofar as the various particular occurrences of events are unable to be predicted with relative certainty. If an insurance company were to attempt to cover a highly predictable occurrence, then the presence of competition in the insurance market would render coverage for the event unprofitable. In such a situation, it would be cheaper for one to save up money oneself, as the insurance company would not be willing to charge less than what it knows it would have to pay out in the future. In addition, it would also have to charge additional expenses to cover its operating costs, rendering its service more expensive than merely saving up for this impending disaster oneself. An example of something an insurance company may be unwilling to cover is the purchasing of glasses, contacts, or laser eye surgery for a client who is known to have deficient eyesight prior to being covered. The insurance company would understand that it is highly likely that this client would need to purchase some good or service which treats deficient vision. Thus, in order to be profitable, the rate the agency would have to charge for this coverage would cost the prospective client more than if he just purchased said good or service directly. Mises clarifies the strict distinctions between classes and members of a class:
We have a complete table of mortality for a definite period of the past in a definite area. If we assume that with regard to mortality no changes will occur, we may say that we know everything about the mortality of the whole population in question. But with regard to the life expectancy of the individuals we do not know anything but that they are members of this class of people.[3]
Another condition that renders a particular event “uninsurable” is whether or not its occurrence can be largely affected by the prospective client’s individual actions. In other words, if one is able to affect the risk of an event transpiring through his deliberate behavior, then this event is not one for which insurance is economically viable. Hoppe elaborates:
Every risk that may be influenced by one’s actions is therefore uninsurable; only what is not controllable through individual actions is insurable, and only if there are long-run frequency distributions. And it also holds that if something that was initially not controllable becomes controllable then it would lose its insurability status. With respect to the risk of a natural disaster — floods, hurricanes, earthquakes, fires — insurance is obviously possible. These events are out of an individual’s control, and I know nothing about my individual risk except whether or not I am a member of a group that is, as a group, exposed to a certain flood or earthquake or fire risk.[4]
Imagine a scenario involving Florida coast customers purchasing hurricane insurance. Obviously, their choice to live near coastal areas will be reflected in the premiums they pay. This is because the insurance company will group them with others who have similar overall risks to be hit by hurricanes as determined by relevant meteorological or geographical criteria. Relative to the other members in the insurance pool, one’s individual actions will not increase or decrease the chance of being hit by a hurricane. The insurance company will. however, likely assess what measures one has taken to mitigate hurricane damage. For instance, it may offer lower premiums if a given client constructs twenty-foot concrete walls around his residence. Such actions will be what are used to determine pooling, and, in turn, what premiums will be charged. Any additional risks taken by subsequent actions not considered in the risk appraisal will likely not be covered by the insurance agency. That is to say, relevant individual behaviors or actions not expressed to the insurance agency when it appraises one’s risk fall into the realm of personal/individual responsibility, of which the insurance company has no part.
An example of something that is undeniably uninsurable is aggression (as defined in Chapter 1). Any given person is fully in control of whether he/she decides to commit aggression and, as such, no insurance can be taken out for this action. An insurance agency which attempted to insure clients against the risk that they themselves will commit aggression will soon go broke as clients will be incentivized to engage in aggression for the sake of receiving insurance payouts. This should make clear the financial untenability of offering insurance against those risks which are largely within one’s control.
On the other hand, any insurance company that refuses to pay out for covered claims would be considered fraudulent. Should the insurance company be found to be in breach of contract, then the matter may be handled via private arbitration. The arbitration agency used and the process taken for any perceived breach in contract will have likely been agreed upon in advance by the client and insurance company in their service contract. As most people are concerned with the threat of not being indemnified, they would likely prefer those insurance companies which account for such contingencies as opposed to those which do not. As a consequence, the former insurance companies, other things equal, would tend to drive the latter ones out of business, or cause them to change their own policies accordingly. However, even absent any legal rulings, if a given insurance company develops a reputation for not granting legitimate payouts to its clients, then it would quickly lose business to competitors with greater integrity. Of course, it would also be in their competitor’s best interest to maintain watch over this type of foul play so as to absorb any disgruntled clients.
Unfortunately, in today’s environment, the utility and cost of insurance is greatly skewed against the consumer’s favor by State interference taking the form of regulations, taxes, minimum coverage requirements, and prohibitions against various types of discrimination – up to and including pre-existing conditions in the health insurance markets. Regulations and licenses serve as aggressive barriers to entry into various industries, resulting in decreased competition, higher prices, and less availability. Mandated coverage requirements force many to buy more than what they need, neglecting what those resources could have serviced if they were tailored to one’s personal situation.
The preceding analysis is simply meant to be an evaluation of what types of insurance practices will be financially viable in a free market and which ones will not. There is no question that any insurance company has the right to offer coverage for anything it deems appropriate, to include insurance against suicide or self-inflicted arson; however, such practices will result in huge losses and business to their more sensible competitors. Thus, the true scope of that which may be covered efficiently and to what extent will ultimately be revealed by the market place in the varying degrees of profits and losses. Remember, profits earned without aggression or legal favoritism represent value added to society, as they require an entrepreneur to combine certain inputs in such a way that they are worth more together than the sum value of their separate components. Businessmen can be relied upon to work in pursuit of providing value to society as a whole, for achieving this end results in their greatest personal gain. The market place reveals the illusion of the personal gain/social gain dichotomy and instead serves to align the two, the only assumption being that man acts towards his own interests. As for those who do not add such value, their command over resources will be diminished in the form of losses and be increasingly transferred to those who use them in such a way that provides the most value to society (as measured by profits). This is the way in which markets perpetually equilibrate in light of the ever changing advancements in technology, consumer demand, and the supplies of various goods so as to allocate scarce resources in a manner most favorable to both our long and short term interests.
References
[1] Hans-Hermann Hoppe, “Economics of Risk and Insurance” (lecture presented at the annual Mises University, Auburn, Alabama, July 2001.
[2] Mises, “Class Probability” in Human Action, 107.
[3] Mises, ibid, 107-108.
[4] Hoppe, “Economics of Risk and Insurance,” 2001.
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