Stephen A. Moses, "The Inherent Individualism of
Insurance," Navigator, Vol. 5, Nos. 10-11, November-December 2002,
pps. 10-12, 14-16, published in January 2003.
The Inherent Individualism of Insurance
By Stephen A. Moses
As human beings, we fear chaos and confusion and fight
against them. We appreciate order. We celebrate reason, logic, and science
because they help us bring order and manageability to our experience of
reality. But no matter how rational and focused we are, we remain
vulnerable to unexpected events that can throw our lives into turmoil. A
slippery sidewalk, an unanticipated illness, a drunken driver, a freak
storm, or (who knows?) an errant meteor. Besides, "the best laid plans of
mice and men oft go astray." We need a tool to help us mitigate the
consequences of uncertainty in day-to-day life, just as reason and logic
help us to bring order and predictability to cognition. Fortunately, we
have such a tool: it's called insurance. Insurance cannot repair the
damaged or heal the sick, but it can alleviate the economic consequences
of unpredictable negative events like accidents, natural calamities, and
illness or death.
What is insurance and why do we need it?
"Insurance" is a financial tool with which we can
replace the small risk of a catastrophic financial loss with the certainty
of an affordable payment. Insurance companies help people achieve this
objective by spreading and pricing risk. For example, let's say there is
one chance in a million that I will be hit by a truck, resulting in a $1
million loss. That event—unlikely as it might be—would devastate me
financially as an individual. I would gladly pay $2 to make the monetary
part of this risk disappear. So would millions of other people. Therefore,
an insurance company can profitably sell such protection, called an
insurance "policy," to me and to 999,999 others for a reasonable fee,
called a "premium."
The insurer promises to "indemnify" me and all other
policyholders (or "insureds") if and when the insured event occurs by
paying us a specified "claim" amount that restores us to our financial
position before the loss occurred. If the company sells one million such
policies for $2 each and incurs the anticipated single "loss" of $1
million, it makes a hefty 100 percent profit and performs a valuable
public service in the process. The insureds can relax and enjoy life in
the knowledge that if the worst happens, at least they are protected
financially. That is called "spreading risk." But what if five of the
insurance company's beneficiaries are hit by trucks instead of just one?
Then the company would have collected only $2 million in premiums, but
would owe $5 million in claims, a $3 million loss. To know what to charge
for insurance protection, companies must "assess the risk." They must
measure, record, and analyze extensive "actuarial" data on the incidence
and frequency of the insurable event. In other words, they must answer the
question: What is the probability that the insurable event will occur to
individuals among the insured group and what will be the cost if it does?
That is called "pricing the risk."
Of course, they cannot say with certainty whether you or
I may be the victim, but they can say with a high degree of confidence
what level of risk we face as a group of individuals. Thus, insurance
makes it possible for us to "transfer risk" from ourselves as individuals
to a third party, the insurance company, in a voluntary commercial
relationship that benefits both parties. The insureds gain peace of mind.
The insurer gains profitability.
So far so good. But what if I want to buy insurance
because I know I am very likely to need it? This is called "adverse
selection," and insurance companies must discourage it. Or else, what
would happen if I bring more risk into the risk pool than you do? Would it
be fair to charge me the same premium as you have to pay? In fact, would
you even purchase an insurance product that guaranteed to give a higher
return on average to other, higher-risk insureds than to yourself?
For example, say that I am a heavy smoker and I am
therefore more vulnerable than a non-smoker to emphysema and lung cancer.
If I'm already sick, selling me health insurance would be like providing
fire insurance to someone whose house is already in flames—blatant adverse
selection. But even if I'm not yet ill, if I were to pay the same premium
for health insurance as a non-smoker, I would be getting more protection
for my money, dollar for dollar. That's because, as a smoker, I would be
much more likely than the non-smoker to file an insurance claim for
medical treatments related to my unhealthful behavior. Put another way,
the non-smoker would be subsidizing my health insurance premium by paying
a higher premium himself than the level of risk he brings to the risk pool
Thus, insurance companies must not only assess but also
"classify" risks. They do this through "underwriting." That is, they ask
questions, examine evidence, or do tests to determine the level of risk
that each individual or class of individuals brings into the "risk pool,"
so they will know how much premium to charge each insured or group of
insureds. Thus, your insurance company may examine your driving history or
review your medical records before underwriting you for auto or life
insurance, for example. If insurance companies failed to classify risks in
this way, the whole system would fall apart very quickly.
In the example of the smoker and the non-smoker, the
non-smoker—unless he's an inveterate altruist—would get smart sooner or
later, drop any health insurance that punished him financially but
rewarded smokers, and look for a policy that treats everyone fairly. This
would have a devastating effect on the "reserve fund" that insurers must
maintain and invest. Insurers need reserves to pay claims when they occur,
to cover administrative costs, and, of course, to return an acceptable
profit to their investors or shareholders. When non-smokers, i.e., "good
risks," drop their policies and stop paying premiums while smokers, i.e.,
"bad risks," keep their underpriced policies, something has to give.
Either the insurer must raise premiums for the remaining smokers covered
by the policy to ensure sufficient reserves to pay the higher anticipated
claims or the reserve fund will become "insolvent," i.e., insufficiently
capitalized to pay expected claims. Either way, nobody wins.
Another beneficial effect when insurers classify and
price risk accurately is to encourage positive behaviors and discourage
negative behaviors. The price of insurance should alert us to the
long-term cost of our decisions. When insurance is very expensive, it
sends the message that our conduct or condition may be excessively risky.
For example, people who have poor driving records usually pay higher auto
insurance premiums, sooner or later. Their careless or drunken driving may
have little or no cost for a long time. Once a traffic ticket is issued,
however, it becomes part of the public record. An auto insurance company
can review the public record and raise the violator's insurance rates to
reflect the added risk he brings to the risk pool. On the margin, this
added cost associated with carelessness or illegality tends to discourage
irresponsible behavior and reward responsible behavior. Conversely, over
time, if one's driving record improves, one's insurance premiums will
decline once again to reflect better performance, thus rewarding improved
behavior. Insurance achieves this positive social effect justly and
without coercion by objectively pricing the risky behavior of individuals.
Even when our behavior is not dangerous to others or
otherwise irresponsible, however, accurately priced insurance premiums
still give us valuable personal information and promote fairness and
equity. For example, why should a sedate philosophy professor pay the same
life insurance premium as a skydiver or motorcycle daredevil? There is
nothing wrong with the adventurous life, but insurance helps make sure
that those who choose it take their fair share of the fiscal, as well as
the physical, risk. Properly conceived, therefore, private insurance is in
many ways a marvelous early warning system for us both as individuals and
as a society.
Notice, finally, that insurance is different from
saving, though the two are intimately related as ways of preparing for
future needs. When we save, we are putting money aside for future use,
normally in an account or investment that earns a return; we retain the
money rather than paying it to someone else, and we get back only what we
put in (plus interest or dividends). We can use savings to deal with
various risks, but saving per se does not spread risks among people and
thus does not require the kind of risk classification that insurance does.
Insurance and savings can of course be bundled together
as products. An example is whole life as opposed to term life insurance.
When you buy a whole life policy, you are not buying pure insurance; you
are investing a portion of your premium with an insurance company. Most
people can invest their money much more profitably through independent
investment vehicles. In the same way, most managed-care health plans cover
both unpredictable catastrophic illness or injury and routine, predictable
medical expenses like annual checkups. In effect, managed care is a
combination of a lay-away plan for routine care and insurance for
catastrophic care. Bundling those functions together is generally not a
good idea—though in this case government policies have pushed most people
in that direction.
Why and how is insurance corrupted?
Well, if insurance is that wonderful, why do so many
people have such a bad opinion of it? What's the "rap" against private
insurance? Maybe the following comments will sound familiar:
"Private insurance is heartless. It blames the victim.
It punishes people for conditions that are no fault of their own." For
- Health insurance callously excludes anyone with a
serious pre-existing medical condition.
- Home owners insurance may be prohibitively expensive
for otherwise fine citizens who just happen to live in crime-infested
- AIDS patients can't get life insurance, and
Alzheimer's patients can't get long-term care insurance, even though
these are the people who need the protection most.
Are these legitimate criticisms? No, of course not.
Insurance is a business, not a charity or a welfare program. Private
charity or government welfare programs may be legitimate ways to help the
uninsurable, but that's a different issue. To achieve the benefits I
described earlier, insurance must remain a business enterprise, motivated
by self-interest, regulated by competition, and priced by objective
evaluation of risks and returns. When politicians, bureaucrats, or
"advocates" of one kind or another try to achieve welfare goals through
private insurance—when they try to "improve" on private insurance with
mandates, controls, or regulations—all sorts of unforeseen and unintended
Here is how it starts. In the interest of protecting
consumers, someone insists that insurance should be required to cover a
benefit that was previously not covered or covered only as an optional
benefit for an added premium. Or, in the interest of assisting the
uninsurable, someone demands that everyone should be able to buy insurance
and that premiums should not exceed "reasonable" levels. Or, in the
interest of helping people who are vulnerable to certain illnesses,
someone wants to prohibit the collection and review of medical or genetic
information by insurance companies.
Demands for politically induced insurance "reforms" like
these start small and quietly. They build over time with growing support
from the often small minority of individuals who stand to benefit most
from the changes. Gradually, interest groups mobilize to represent the
benefit seekers and to promote their claims. A relatively small number of
people and organizations have a relatively intense interest in promoting
laws that benefit them.
Opposition remains quiescent for two main reasons.
"There but for the grace of God go I," think some. "Maybe this new law
will actually help me someday." Others think, "I should not
begrudge the less fortunate their getting something from private insurance
companies. After all, those companies have deep pockets and, even if they
pass the cost on to me, how much more will helping the needy cost me
anyway?" Most people do not understand the trade-offs between a free and a
controlled insurance market. Others don't care. Thus, whether motivated by
self-sacrifice or the hope of unearned gain, by ignorance or apathy, most
people go along to get along, supporting government intervention in the
All of these interventions attempt to reduce the cost of
insurance protection for high-risk individuals by increasing the cost to
low-risk individuals. Therefore, their purpose and effect is not to reduce
risk but to spread wealth. Like other egalitarian measures, they unjustly
grant unearned benefits to some while imposing undeserved penalties on
others. And, accordingly, the results are destructive. There is an old
saying that "you get more of what you subsidize and less of what you tax."
By subsidizing high-risk behaviors and conditions while taxing low-risk
behaviors and conditions, these measures have exactly the opposite effect
of the benign results we attributed earlier to private insurance. They
reward irresponsible behavior and punish responsible behavior, creating a
downward spiral of perverse incentives.
Regulation, Welfarization, and Social Insurance
Government efforts to improve on private insurance fall
into two major categories. First is the regulation of private insurance
through "prior approval," restrictions on risk classification, and
mandated coverage (that is, the company must offer certain types of
insurance in the state if it offers any). In the second category are the
"social insurance" programs that government itself provides.
The first tactics used by state regulators were prior
approval of insurance rates, policy forms, or both. Historically,
insurance regulation has been a state-level function with relatively
little federal involvement. Insurance companies that wish to market a
policy nationally must file for approval in all 50 states. Each state has
different requirements, some stricter than others; the most rigid states
require the use of state-mandated rates or forms. Frequently, the
regulation of insurance becomes the politicization of insurance and then
the welfarization of insurance. According to testimony given before
Congress by Robert E. Litan, co-director of the American Enterprise
Institute-Brookings Joint Center on Regulatory Studies:
Regulated rates are often distorted by political
pressures in order to subsidize certain classes of drivers. The AEI-Brookings
study found evidence that not only does regulation often suppress
average rates, but distorts rates between different classes of
drivers—keeping rates for high-risk drivers artificially low, while
raising rates for lower-risk drivers. This cross-subsidization is
accomplished directly through limits on rates in certain
classifications…. The Massachusetts case study, for example, found that
some high-risk drivers receive subsidies as high as 60 percent,
requiring some lower-risk drivers to pay 11 percent more in premiums
than they would pay in a competitive environment ("State Regulation of
Auto Insurance," Testimony before the Subcommittee on Oversight and
Investigations of the House Committee on Financial Services, August
The obvious solution to bring the market back into
equilibrium is to eliminate the rate caps. That is hard to do, however,
because advocates for the "disadvantaged" who live in high-risk urban
areas insist that the caps favor consumers and that dropping the caps
would benefit only the insurance industry by allowing it to charge higher
premiums. All too often, the media accept and promulgate this argument.
Thus, for reasons discussed above—vested interests for some, forced
altruism for others, and ignorance or apathy for most—such insurance
"reforms" tend to remain in place and other similar measures constantly
gain support and adoption. I call this process the "welfarization" of
insurance, that is, the transformation of private insurance by government
intervention from a market-based product into a tool to improve the
condition of some people in relation to and at the expense of others.
Another form of welfarization is to impose restrictions
on risk classification. As explained earlier, insurers must classify kinds
and levels of risk carefully to avoid "adverse selection" and to price
policies accurately in accordance with the levels of risk that various
policyholders bring into the risk pool. In the absence of risk
classification, smokers and non-smokers, good and bad drivers, daredevils
and college professors would pay identical premiums.
An example of insurance "reform" that eliminates or
severely restricts risk classification is "community rating," which
requires that insurance premiums reflect the average risk in a geographic
region. Under community rating, the level of insurance premium for
everyone is determined by adding up the cost of paying benefits for
everyone—rich and poor, sick and well, responsible and irresponsible—and
dividing by the total number of individuals in the covered population. To
many people, this sounds like a fair and effective way to address the
endemic problems of unaffordability and the uninsured, especially in the
case of health insurance.
But look at what happens. Low-risk insureds soon realize
that they have to pay more for insurance than was the case before
community rating, and they tend to drop such over-priced coverage.
High-risk insureds, on the other hand, have every reason to keep their
under-priced coverage. In fact, high-risk people who were previously
uninsured tend to purchase this highly attractive new insurance.
Gradually, the risk pool becomes heavily weighted with people who are
highly likely to file claims. Insurance companies begin to lose money and
must either raise premiums to remain solvent or stop offering the coverage
altogether. If the insurer raises premiums, the coverage becomes less
attractive to low-risk insureds, further exacerbating the problem. Sooner
or later, the only viable option for insurance carriers is to drop the
policy and leave the state. The money they can collect from premiums will
not cover the anticipated expenditures for claims, much less return
administrative costs and an acceptable profit.
Viewed logically and analytically, this outcome seems
obvious. But that has not stopped real-world regulators from imposing
community rating and unleashing the inevitable consequences. For example,
New York legislators mandated community rating for health insurance in
1993. The National Center for Policy Analysis summarized the effects:
Consider the impact on policies sold by Mutual of
Omaha, one of the largest sellers of individual health insurance
policies in the state:
- Before community rating was instituted in New York, a
25-year-old male on Long Island paid $81.64 a month for health
insurance, and a 55-year-old paid $179.60.
- After community rating, both paid $135.95, a 67
percent increase for the 25-year-old and a 25 percent decrease for the
- Because young, healthy people began canceling
policies, by 1994 both paid $183.79—more than the 55-year-old was paying
before community rating was implemented—and by 1997 that community-rated
premium had risen to $217.59 a month.
As a result of the departure of thousands, the uninsured
population in New York City grew from 20.9 percent in 1990 to 24.8 percent
in 1995, according to one report, while the national rate grew from 16.6
percent to 17.4 percent over that same period. ("Explaining the Growing
Number of Uninsured,"
In Kentucky, the same tactic prompted 45 of 47 insurance
companies to withdraw from the state's individual health insurance market.
Market failure caused by government intervention then became one more
reason in the minds of politicians to impose even more government
intervention—a chain reaction that leads deeper and deeper into political
manipulation and further dysfunction.
In addition to manipulating private insurance,
government has created its own insurance programs—with equally
unsatisfactory results. "Social insurance" is the idea that we should all
pay the same premium, usually in the form of a payroll deduction, and that
we should all be entitled to the same benefits regardless of the level of
risk we bring to the global risk pool. America's Social Security and
Medicare programs are social insurance systems. Both of these programs are
enormously popular. Many people consider them to be unqualifiedly
successful. Similar and more extensive social insurance programs in Europe
have even greater popular support despite the enormous tax burden they
impose on wage-earning participants.
Nevertheless, these programs are highly destructive. For
one thing, social insurance is a pay-as-you-go system, and thus a Ponzi
scheme. The government does not invest the payroll taxes it collects from
workers in order to support their future benefits. Rather, it pays
out their taxes to current retirees; when those who are currently working
and paying taxes retire, they will have to depend on taxes from the next
generation of workers. This system seemed to work early on when a large
number of people were paying into the system while only a small number of
people were drawing benefits out. But, in the future, as Europe, the
United States, and the rest of the world confront a new demographic of
aging, analysts say a shrinking pool of workers will be unable to support
full social insurance benefits for a retiring baby-boom generation of
gigantic size and unreasonably large expectations. If warnings from the
General Accounting Office, the Congressional Budget Office, and dozens of
independent experts are accurate, Social Security and Medicare will leave
both their participants and the government worse off in the long run.
Insurance performs the critical economic functions of
spreading risk and of pricing risk. If we do not price risk fairly
and objectively, we end up with a system that rewards high-risk (including
irresponsible) behavior and punishes low-risk (including responsible)
behavior. One of the main differences between social insurance and private
insurance is that, although both spread risk, only private insurance
prices risk in a meaningful way. Private insurers have a legal and
fiduciary responsibility to their insureds. They must price insurance
coverage at a level sufficient to accumulate reserves that will be
adequate to pay carefully anticipated claims rates. Private policyholders
possess legal contracts, enforceable in a court of law, that assure them
recourse in case of dispute, malfeasance, or insolvency by the insurance
Social insurance, on the other hand, offers none of
these protections. Social Security and Medicare, for example, are
notorious for growing exponentially beyond their original cost
projections. Socially insured people have no legal recourse or protection
against increases in premiums (payroll taxes), decreases in benefits
(program cutbacks), or the imposition of means tests (welfarization).
In America's mixed economy, social insurance is usually
considered a safety net and not a first line of financial defense. When
savings, investments, pensions, and private insurance prove inadequate, we
look to social insurance to pick up the slack. Unfortunately, however, the
very existence of compulsory social insurance debilitates the
effectiveness of these private financing vehicles. People save or purchase
insurance if they perceive they are vulnerable to a large financial
loss. Social insurance distorts that perception. By creating an illusion
of low risk, it reduces the demand for private insurance protection.
For example, when President Lyndon Johnson signed the
act that created Medicare in 1965, he stated confidently that "no longer
will older Americans be denied the healing miracle of modern medicine. No
longer will illness crush and destroy the savings they have so carefully
put away over a lifetime so that they might enjoy dignity in their later
years. No longer will young families see their own incomes, and their own
hopes, eaten away simply because they are carrying out their deep moral
obligations." By building up false hopes like these, Medicare effectively
scuttled any hope for a private health insurance market to cover seniors.
Today, the elderly spend a larger proportion of their income for health
care than they did before Medicare began; Medicare has little hope of
continuing to provide full benefits without major premium increases as the
baby-boom generation retires; and a private insurance system to take
Medicare's place has no realistic chance to develop.
The same problem occurs in other categories of
insurance. Most people buy private car, fire, and life insurance. If they
did not have these kinds of coverage and the insurable event occurred,
they would usually experience a major loss with little direct assistance
from the government. On the other hand, very few people purchase
hurricane, flood, or earthquake insurance. When a major natural disaster
occurs, local and national politicians jump at the opportunity of
promising financial assistance of all kinds to the victims. Nothing lets a
politician appear compassionate and generous without fear of criticism
like a major disaster. Why buy flood insurance if the government
indemnifies you with grants and loans every time the Mississippi escapes
its banks? In the same way, the marketability of private long-term care
insurance is also undercut by the easy availability of nursing-home care
financed by Medicaid. One can only wonder at the possible effect on
private life insurance sales of the government's liberal indemnification
of families victimized by the World Trade Center attacks.
Thus, government impedes the effectiveness of private
insurance in two main ways: first, by trying to improve on private
insurance with arbitrary controls; secondly, by allegedly mitigating the
risks against which private insurance should protect us through mandatory
social insurance, public welfare, and emergency grants and loans.
Insurance and Morality
We have seen that insurance performs a vital economic
function. To the extent that government regulates or subsidizes insurance,
it also becomes a political issue. But insurance has a moral
dimension as well. Insuring against risk is one of the most important ways
in which individuals take full responsibility for their lives, in
accordance with the ethics of Objectivism. And the private marketplace for
insurance illustrates how trade allows individuals to cooperate for mutual
* Insurance is individualistic.
Individuals buy insurance by voluntary choice to protect their own
self-interest (including the interests of their loved ones and dependents)
in accordance with their own assessment of their individual needs and
* Insurance is rational and objective.
It helps us prepare for the unexpected based on facts and analysis, so we
don't have to depend on wishful thinking or blind hope. Premiums and
benefits are based on objective risks as determined by hard actuarial
* Insurance depends on the trader principle.
You won't buy it and the insurance carrier will not sell it unless you
each perceive that the transaction will leave you both better off than you
were before. When this simple principle is allowed to operate in a free
market, the result is a profusion of different policies—covering a wide
range of risks, benefit levels, terms and conditions, and durations—that
an individual can tailor to his unique situation, with prices controlled
* Insurance is fair. You know
you get what you pay for because your premium is based on underwriting,
which measures and prices the level of risk you bring to the risk pool.
Nobody forces you to buy insurance, but if you don't have it, you are
responsible for the punishing financial consequences if and when the
insurable event occurs.
* Insurance serves life. It
helps us to manage uncertainty and therefore preserves, sustains, and
By contrast, social insurance violates those same
* Social insurance is collectivistic.
It treats individuals as means to an end by sacrificing
their interests for the sake of others.
* Social insurance is subjective.
"Premiums" and benefits are based on political considerations and are
established by the authorities.
* Social insurance is non-rational.
You pay what it charges and get what it gives you without regard to any
reasoned calculation of what you want, what you need, or what you can
* Social insurance is inequitable.
By treating everyone the same, it punishes some people (the most
responsible and least risky) to reward others (the least responsible and
* Social insurance violates the trader principle.
It is compulsory and monopolistic. It prevents people from choosing to opt
out; it offers a single policy with few options, if any; and it is not
subject to competition.
* Lastly, social insurance undermines life.
It creates a false sense of security that anesthetizes people to risks
that they must recognize and confront to live safely.
For all these reasons, it should be clear that "social
insurance" is not a type of insurance but its antithesis. It is not a
means of dealing with the chaos and confusion of life; it is a source of
chaos and confusion. Because social insurance rests on the politics of
demagogy, it renders future freedoms and obligations unknowable, and so
vitiates our ability to plan. Because social insurance operates through
taxes, it robs us of our money—the principal tool we need to give
substance to our plans.
The question, then, is not whether social insurance
should become private. That is like asking whether drunk drivers should
become sober drivers. Of course they should. And social insurance thus
needs to be fought through a well-grounded moral crusade, carried to the
voting public through lectures, articles, and other means. But until
politicians show an inclination to give up their demagogic joy rides, the
uncertainties generated by social insurance will remain a personal threat,
compounding the uncertainties that are inherent in life. Although we
cannot entirely escape the cost of government intervention, we can gain a
measure of independence by refusing to rely on government's offer to help.
We can and should use genuine insurance—private insurance—to build a wall
of private protection between ourselves and life's uncertainty that
depends as little as possible on government promises and programs.