How not to reform the insurance industry

Browsing the comments on Scott’s blog recently, I came across an interesting suggestion for reforming the insurance industry.

If I were declared supreme fascist dictator of the world (which would be GOOD for the world), I’d decree that insurance companies had some specific fixed amount of time to investigate a client and return the premiums not consumed by that investigation. After that, unless they could prove deliberate fraud they were on the hook for their contract.

– William O. B’Livion

However, this is probably a pretty bad idea.

At the moment insurance companies only need to investigate clients who make a claim. If enacted, this would require insurance companies to investigate at length everyone who took out a policy.  As such, investigation costs would be much higher, requiring higher premiums for everyone.

Additionally, at the moment there is an implicit punishment for attempting to cheat an insurance company: you pay the premiums, but then don’t get the payout, so the premiums paid act like a fine for your attempted fraud. If insurance companies had to investigate at the very beginning instead, people would have more incentive to try to defraud insurance companies, as there would be less cost. As such, both fraud and anti-fraud costs would rise, both of which require an increase in premiums for everyone.

Finally, at the moment these foregone premiums go to the insurance company. As the insurance market is pretty competitive, this money ultimately results in lower premiums for honest customers. Requiring insurance companies to investigate immediately would take away this cross-subsidy and again raise premiums for everyone.

So it turns out that, like most such suggestions involving restricting people’s ability to freely sign contracts without any clear market failure identified, the proposal is a bad idea. Perhaps this might be a popular policy, if people somehow ignore the costs, or assume they’re being paid by evil corporations. Indeed, this might even be popular with incumbent insurance companies, if the high upfront costs of investigation it would require act as a barrier to entry and protect them from competition. As usual, ultimately the consumer pays. But it’s interesting how, in exploring why it’s a bad idea, we come to appreciate more the virtues of the current system.

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