Insurance vs welfare

9/22/2017 08:57:00 AM

There's been a debate on twitter lately about the proper role of insurance in healthcare. Alex Tabarrok summarizes the proposition being debated:

The basic idea Tabarrok is getting at is that insurance is a security that reduces the variance in your expenses, while a scheme that reduces the expected value of your expenses is more properly understood as redistribution (or, in non-econ speak, welfare). Those are fine definitions, I suppose, even though they do not conform to everyday usage of the terms. I think we can understand community-rated insurance like employer-sponsored plans or ACA exchange plans as containing a mix of both health-based redistribution and pure economic insurance. Lots of people in these plans would not be able to afford them without the "redistribution" if that's what you want to call it.

Still, philosophically, this is a weird distinction to make. Analytically, insurance and redistribution are the exact same thing. You can take the exact same security and it will be either insurance or redistribution depending on the state of mind of the policy holder and insurer. In a risk-rated insurance market, if I have leukemia and don't know it yet, then I can afford to buy insurance that covers leukemia treatment, so this is a true Tabarrokian insurance contract. But if I have leukemia and do know it, then insurers will bake the cost of leukemia treatment into my premium and I won't be able to afford it. The exact same contract is insurance if I'm sick and I don't know it, or welfare if I'm sick and I know it. What a strange distinction!

This is where John Rawls was coming from. The moral case for insurance coverage of leukemia treatment shouldn't depend on who knows you have leukemia. This is why we often refer to welfare as "social-insurance." All welfare is an insurance contract, but re-imagined under an alternative information set.

Information sets do matter, economically, of course. Adverse selection happens when insurance customers have more information about their future health costs than insurers do. Community rating forces insurers to price their products as if they know nothing about individual-specific health risks, but because customers do have information about their own health risks, we're at risk of adverse selection. Whether we are talking about insurance or redistribution, information sets constrain the set of possible outcomes. If you want both a healthy person who knows he is healthy and a sick person who knows he is sick to be able to have insurance, you must ensure that the design of this scheme includes enough incentive to persuade the healthy person to buy it. This is called an "incentive compatibility constraint." The ACA does this by taxing people without insurance, which is implicitly a subsidy for healthy people who buy insurance. Risk-rating schemes do this by charging more to sick people, which is implicitly a subsidy for healthy people who buy insurance. The process of designing a scheme to achieve the best outcome possible without violating the incentive compatibility constraints given the real-world information set is called "mechanism design." The scheme, whether it is a private insurance contract or welfare, is called a "mechanism."

I don't particularly care whether we call this mechanism "health insurance" or "redistribution." Tabarrok draws a distinction based on information sets, which do matter for the feasibility of the design of the scheme, but the moral case for each is identical.