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If not happy, then optimistic. One of my students made the nice observation that insurers must be the most optimistic people in the world. Think about why? “They” are placing bets that bad things will not happen to you. And if you think about the multiple types of incentives at play within insurance companies, let’s compare how two competing visions of them work.

  1. Insurers are greedy profit-mongers. As such, they sign up lots of people for coverage, only to deny them and drop their coverage when they learn about a negative outcome.
  2. Insurers are greedy profit-mongers. As such, they sign up lots of people for coverage, and want to make sure they stay as premium paying customers as long as they can, without having to pay out a claim. (*)

Note that each of these has opposite implications for the way insurance companies actually behave. There are two analogs to help you understand why behavior 2 is very likely to be a stronger force than behavior 1, and both arise from the fact that I think it is plausible that insurers hope to be around tomorrow and into the future. First, Mancur Olson made himself famous for thinking about how countries have developed over time. The reason we can rise above our miserable subsistence lives is that we’ve moved from a world of roving bandits to a one where there are lots of stationary bandits. In a world where bandits are much like marauders, the way to get rich is to come to a village and pillage and plunder as much stuff as possible and then move onto the next village. So long as there are large numbers of villages and the number of plunderers is small, well, then, you are likely to see this as a stable equilibrium.

Consider an alternative way of plundering. You are bandit, and for various reasons you do not wish to move onto the next village – you happen to like the scenery in the one you are currently in. In this case, while perhaps you still like to plunder and pillage, you can’t do it in totality. Why? Because by sticking around, you would like to insure yourself a steady supply of booty for the future – and the only way to do that is to treat those you are plundering a little bit better. In other words, you need to keep your host healthy, or at least happy (I am thinking bread and circuses here – sort of what is going on in the US today).

A second analogy is thinking about the incentives for central banks to inflate away their currency. Now, the long term record of the Fed and other Western central banking systems is not exactly great – for example, the value of the dollar has fallen by 96% since the Fed was established. However, annual inflation rates have tended to be low, and somewhat predictable. If the central banks earn “seigniorage” by inflating away their currency, as they do, you might be surprised that we have not seen inflation happen at much higher rates – particularly as we fund larger and larger and larger government each year. So what gives? Essentially the central banks face two choices – inflate rapidly so that we can extract one-time massive profits via the inflation tax; or they can choose to have a low and predictable rate of inflation, thereby assuring that they can continue to do so for a very long time in the future. Clearly in “stable” Western democracies, the latter is preferable. In unstable countries and less developed countries, it should be no surprise that inflation is commonly much larger.

Now think back to our insurance company. The conventional view is that they are like the roving bandits of old. My view (note we do not need to make normative claims about their morality and goodness) is that they are much more like the stationary bandits of modern society. So even if you think there is a raw desire to treat people miserably, their greediness actually encourages them to help their customers incur less risk and still remain paying customers. In that way, everyone wins out. Keep that in mind the next time the Administration demonizes Well-Point for possibly dropping customers who try to file claims. Treating customers badly is bad business. In fact, the only people that can get away with regularly treating their “customers” badly are those that are insulated from competition and those that have a few small weapons at their disposal. I wonder who that might be?

(*) I leave out the “economic problem” that because of these incentives, insurers would seem to have an incentive to only cover the lowest risk people. Of course, the standard economic theory of information markets suggests that the way insurance markets break down is by low risk people opting out of the insurance market, leaving only the high risk people in the pool.

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