Insurance and Public Utilities

As I begin to explore the health care debate, I think it's important to start with a review of insurance. Health insurance is the central point of the debate; President Obama has even modified his language to speak of the need for "health insurance reform" rather than "health care reform." To illustrate, visit the official site of the White House or read this letter from Senior Advisor David Axelrod.

The basic concept of insurance is simple and widely used. As a formal financial product, it is actually relatively new. One can imagine the early beginnings of insurance when a community of citizens would offer to provide mutual assistance to each other if one had a disastrous event such as a fire. If you are interested in the history of insurance, check out this Wikipedia entry.

A simplistic description of insurance products in the private sector can be described as a service to pool risk. A group of people collectively pay a regular fixed amount (or premium) to the insurance provider who agrees to pay the costs of a certain event (or, in some cases a set amount of money). Economically, it makes sense that the price of the premiums would be correlated with the expectation of a payout from the insurance company - measured by the probability of the event happening times the size of the potential payout. There is a whole field of study on this called actuarial science.

Now, let's turn to the concept of a public utility. I have previously discussed my limited support of public spending for large investments in infrastructure which serve a public good and the returns on investment are either difficult to measure or take a long time to be realized. This is often the case in situations which economists call a natural monopoly. Typical examples of such public utilities would be road construction, power grids, and sewage lines.

Should insurance (of any type) be viewed as a public utility? Let's examine the characteristics. Insurance does not necessarily require a large investment in infrastructure up front with long, slow returns. The biggest start-up risk to an insurance provider would be a series of unlikely events which would require significant payouts before reserves could be established through the collection of premiums.

Here's a simple example... let's say that there are a group of people who want insurance to protect against an expensive and unlikely event. We'll pretend there are 100 potential insurance customers who, for the purpose of illustration, must pay $1000 if they roll a 1-1-1 on a toss of three dice every Saturday. The odds of any one given individual in any given week needing to pay $1000 is 1/216. While this is unlikely to happen, the people want to avoid having to pay the $1000 so they seek insurance. The insurance provider offers to pay the $1000 on behalf of their customer in return for a monthly premium of $30. The potential customer will pay $360 year to protect them against a $1000 dollar loss which, over the long run, is likely to happen once every four years. In this simple example, the insurance company has about a 0.1% of going bankrupt (with no other expenses other than those from claims) and will operate with a 25% margin. This hardly qualifies as a public utility nor would it lead to a natural monopoly.

But, they could go bankrupt. Bad luck, tighter margins, or poor risk estimates could all plague an insurance company. And, when an insurance company does go bankrupt, they will not be able to pay out on claims which will leave consumers, who have paid their premiums, without coverage. Should the government backstop this risk? I would say that they should not since both parties entered the insurance contract as a way to manage risk. The consumer should know that there is a small risk that they will not be covered by their insurance if the provider itself goes bankrupt.

The analogous situation in our simple of a community joining together in an agreement of mutual assistance in the event of a disaster would be when the community itself suffers a disaster. If all of the houses burns down, then everyone will have to do the equivalent work of rebuilding their own home. This is, in essence, the same problem as "too big to fail" which has been so hotly debated in the world of financial services over the last year.

In summary, I think it is clear that insurance does not meet that basic description of a public utility as I have defined. This, in my opinion, does not make it a good candidate for public investment. There are risks; there are even "too big to fail" risks. These risks can and should be managed via regulations, competition and/or transparency for consumers and investors. It should not be turned over to the state.