The Self-Insurance Alternative

People familiar with insurance have always known that it creates perverse incentives for the insured. In order to take advantage of the benefits under a policy, the beneficiaries do things they would not otherwise do.

In recognition of this fact, insurance in most fields is restricted to risks beyond the control of the insured. (For example, automobile casualty insurance does not pay for oil changes, tire rotations, break adjustments and other routine maintenance - even though these activities are important for the health of a car and the safety of the driver.) Financial advisers almost always recommend high-deductible policies because small-dollar claims are the ones where the most abuse is likely to occur, and the premiums needed to cover these claims are often much too high relative to the extra coverage. The same principles apply to health insurance.

The alternative to third-party insurance is self-insurance. Rather than relying on insurers to pay every medical bill, we could put money aside in personal savings for the small expenses and use insurance only for rare, high-dollar medical episodes. As we shall see, such a practice would result in much lower premiums and curtail a great deal of wasteful spending.

Yet instead of exploiting opportunities for self-insurance and taking advantage of its benefits, in health care we have moved in the opposite direction - with insurers paying for all manner of routine expenses, including checkups and diagnostic tests, even when there is no illness and no risky event has occurred. Why have we failed to apply the lessons learned in other insurance fields to health insurance? The most important reason is the tax law.

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