How can insurance make everyone better off?

After all, the insurance company has to make money. That has to mean that the expected value of the claims they pay out is lower than the expected value of the premiums their customers pay in. In some sense, then, the expected value of your insurance premium is negative.

But insurance does make everyone better off, because it covers very large costs that most people would have trouble paying. Even most really good savers would have a hard time replacing the value of their house, or paying off a $250,000 judgement for an auto accident. The expected value of those incidencts is very, very negative--more than just the value of the cash, you have to factor in the horror of being homeless or bankrupt. When you factor in the homelessness, the bankruptcy, and so forth, the slighly negative expected financial value is more than outweighed by the positive value of being protected against personal catastrophe. Not to mention the peace of mind one gets from not having to worry about homelessness, etc.

This is the magic of risk pooling. But notice that it's the catastrophe which makes insurance a good deal. You wouldn't get much value from buying "grocery insurance". At best, you'd be paying an extra administrative fee to route your routine expenses through an insurer, rather than paying them directly. At worst, you'll end up with bills skyrocketing as all sorts of perverse incentives appear. After all, if the insurer is paying all your grocery claims, why not load up on filet mignon instead of ground turkey?

But insurers try very hard never to sell insurance for less than the cost of your expected claims. If you expect to buy $10,000 worth of groceries next year, it will not charge you less than that for a "grocery policy". And if we all drive up the costs of grocery insurance by consuming more, the insurer can do one of two things: raise everyone's "insurance premiums" to cover a filet mignon budget, or create a list of "approved groceries" that it will cover, and start hassling anyone who tries to file an excessively expensive claim.

Sound familiar?

This is why you should always have liability insurance, but should think twice about collision damage coverage. It's why high deductibles are a good idea--for small expenses, it's better to self insure. And it's why "catastrophic" health plans, which only cover the sort of extremely expensive events that most people would have difficulty financing, are a much better deal than the soup-to-nuts plans that most people get through their employers. Those plans are expensive, both because they're paying for a higher percentage of your expenses, and because they drive up utilization--which means that they drive up next year's premiums even more. Imagine what your car insurance would cost if it covered gasoline, routine maintenance, and those little air freshener trees you hang from the rearview mirror. Then stop asking why health insurance costs so much.

But Kathleen Sebelius, the Secretary of HHS, thinks that catastrophic insurance isn't really insurance at all.

At a White House briefing Tuesday, Health and Human Services Secretary Kathleen Sebelius said some of what passes for health insurance today is so skimpy it can't be compared to the comprehensive coverage available under the law. "Some of these folks have very high catastrophic plans that don't pay for anything unless you get hit by a bus," she said. "They're really mortgage protection, not health insurance."

She said this in response to a report from the American Society of Actuaries arguing that premiums are going to rise by 32% when Obamacare kicks in, as coverage gets more generous and more sick people join the insurance market. Sebelius' response is apparently that catastrophic insurance isn't really insurance at all--which is exactly backwards. Catastrophic coverage is "true insurance". Coverage of routine, predictable services is not insurance at all; it's a spectacularly inefficient prepayment plan.

Now, it occurred to me that Sebelius might be thinking about the scam insurance that is all too often sold to naive, mostly lower-middle-class folks who labor in the service industry. That stuff isn't insurance at all; it's a fraud, and the people who sell it will richly deserve any justice that is meted out to them in either this life or the next. But that stuff doesn't protect your mortgage, either; they're almost-worthless discount plans or very-limited-coverage insurance sold by fly-by-night operations who tend to evaporate as soon as claims have to be paid. So I don't think that's what she's talking about; I think she's talking about catastrophic plans.

Nor do I think that Sebelius is responding awkwardly to a report that the administration would like to wish away. I think she's sincerely confused about the difference between insurance, and prepayment. Which explains a lot about the new health law.

Last week, I was at a health care conference where the subject of catastrophic plans came up. Obamacare has, unfortunately, sharply curtailed the ability to offer these plans; very high deductible plans are now effectively illegal. Which is a great shame, because these plans, combined with a dedicated health savings accounts, were showing real promise at controlling costs.

A liberal policy professor at the event explained this as a result of the toxic political environment surrounding policy these days; since Republicans wouldn't cooperate on Obamacare, Democrats stuck the knife in one of their favorite programs.

But Sebelius' answer suggests another explanation: the Democratic opposition to castrophic plans was not strategic, or vengeful, but entirely heartfelt. The Secretary of Health and Human Services genuinely believes that health insurance should do more than just, well, protect your ability to keep paying the mortgage. Unfortunately, "more" is very expensive and inefficient.