Understanding and Improving Insurance Decisions in the Most Misunderstood Industry Howard Kunreuther Mark Pauly July 2012

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1 Understanding and Improving Insurance Decisions in the Most Misunderstood Industry Howard Kunreuther Mark Pauly July 2012 Risk is an integral part of human existence, but fortunately there are ways to deal with it. One solution is insurance. Insurance allows you to protect yourself financially against a potentially high but uncertain loss relative to your wealth by making a certain and much smaller payment in the form of a premium. But do people potential buyers and sellers of insurance use this tool properly? Often they do not, as we will illustrate below. We are all very familiar with insurance in our daily lives. One would think that this familiarity would translate into wise insurance purchase decisions: trading a small premium for protection against a large loss when the price is right. Similarly, one would expect insurers to utilize data on the likelihood and consequences of specific events to determine a risk- based premium. Finally, one would expect regulators to verify that insurers have enough capital and surplus to ensure their likelihood of insolvency is acceptably low, and that they would permit insurers to charge premiums that reflected risk. Such reasonable behavior by these parties is in many settings the exception rather than the rule. In this article we review research findings and concepts that point the way toward increasing our mutual comfort level when it comes to insurance and improving individual and social welfare. The first step is to explore how consumers think about insurance (when they think about it at all). Many consumers are uncomfortable with insurance there is a separation in time between the payment for protection and the occurrence of an event for which you can make a claim. This interval can be very long if the event in question has a low probability of occurrence, such as a natural disaster causing damage to your property or a severe illness that requires you to be hospitalized. You pay your premiums year after year and normally do not suffer a loss. When you do make a claim, you normally settle for what the insurer agrees to gives you. If you don t like the amount you are offered you can argue about it, often without any success and a great deal of time and energy on your part. Sometimes your insurer tells you that you have no basis for making a claim, as the event in question was not covered by your policy. In such situations you are likely to feel that your premium was wasted. In contrast, when you invest in durable goods, such as an air conditioner, stereo or HD TV, you immediately enjoy the benefits of a more pleasant temperature, higher quality sound of music and clearer images on the screen. In contrast, when you buy an insurance policy, you benefit only when and if you submit a claim for suffering a loss. There is a tendency to view insurance as a bad investment when you have not collected on the premium you paid the insurer. It is difficult to convince people that the best return on an insurance policy is no return at all. Insurance managers have the opposite set of concerns. After they have collected and banked their premiums, they prefer not to pay out very much to their policyholders. They are especially unhappy if their total claim payments in a year are somewhat above average and have a negative impact on their 1

2 balance sheet. Although insurers recognize that they have the potential of suffering a catastrophic loss from a hurricane or a conflagration if they provide significant coverage to those at risk, there is considerable discontent on their part when this occurs. Insurers are concerned if many claims occur simultaneously, as in the case of a windstorm producing losses for all exposures in the affected area. Insurers who cover property losses can sustain large total losses in cases such as hurricanes or terrorism, which makes them very uncomfortable and may cause them to perceive these risks as uninsurable. These tales of woe should by this time already frustrate the perceptive reader. We pose the following questions for addressing the above points: To the person who paid insurance premiums but laments not collecting anything: would the buyer have preferred to be the victim of a major weather event? The buyer is acting as if he was unlucky to suffer no losses because he spared property damage! To the person who filed a claim for damages that was not covered by the policy: shouldn t the buyer know that the terms of a contract will not be changed after the fact? To the insurer: aren t occasional large losses to be expected, which is why it is important to price the risk to reflect this possibility and to accumulate reserves or purchase reinsurance. In the real world of insurance, the actors may not understand or may not accept such rational and disinterested advice. Telling someone with a problem that you should have thought of that beforehand does not engender gratitude for one s wise counsel, whether it is your teenager or your insurance firm s president. The admonition to be rational, in the sense of the economic model of expected utility maximization under risk, often does not conform to how people think, much less how they behave. System 1 and System 2 Behavior The tension between the classical economic theory of rational behavior and behavioral economics with respect to choices made by consumers and insurers is highlighted in Daniel Kahneman s compelling book Thinking, Fast and Slow, where he characterizes two modes of thinking which he labels System 1 and System 2: System 1 operates automatically and quickly with little or no effort and no sense of voluntary control and uses simple associations, including emotional reactions, that have been acquired by personal experience with events and their consequences. System 2 allocates attention to the effortful and intentional mental activities that demand it, including simple or complex computations or formal logic. Kahneman argues convincingly that the distinction between System 1 and 2 helps clarify the tension between automatic, largely involuntary processes and effortful, more deliberate processes in the human mind. Many of the biases that characterize human judgment and choice under uncertainty as the result of using simplified and imperfect decision rules that characterize insurance purchasing behavior are due to the operation of the more automatic and less analytic System 1. The classical economic models of 2

3 consumers maximizing their expected utility and firms maximizing their expected profit require the decision maker to utilize System 2 to make deliberative insurance- related choices in a systematic manner. To illustrate System 1 behavior in the context of insurance, consider the following examples. Consumer Behavior Example 1: Sarah lives in the New Orleans area and has a homeowners policy but not a flood insurance policy. She suffers damage to her home from storm surge due to Hurricane Katrina. She believes that her homeowners policy should cover the loss. Her insurer refuses to pay any claims because the damage was caused by the water and not the wind. Homeowners coverage excludes flood- related damage. Sarah exhibits System 1 behavior by not reading her insurance policy nor does she inquire what coverage was included in the contract. Her insurer did not clearly explain what was excluded from the contract, another form of System 1 behavior. If Sarah had devoted time to System 2 thinking she would have carefully read the homeowners policy, collected information regarding the likelihood and consequences of losses due to flood damage and compared her expected utility from purchasing flood insurance with the decision not to buy this coverage. Example 2: Walter has had a flood insurance policy for 3 years but hasn t suffered a loss. He decides insurance is a poor investment and cancels his policy even though it was required as a condition for his federally insured mortgage. Walter exhibits System 1 behavior by being highly myopic, viewing the premiums he has paid for coverage as a poor investment since he has not received any return in the form of claims payments since purchasing a policy. The bank that holds the mortgage may not be aware of the flood insurance requirement or does not have computer systems that inform Walter that he cannot cancel his policy. System 2 behavior by Walter would have led him to estimate the likelihood of flood damage to his home next year and the potential consequences, so he could systematically determine whether it was financially worthwhile for him to continue to purchase coverage or cancel his policy. He would not have to undertake these calculations if he knew that the bank required him to maintain his flood insurance policy as a condition of his mortgage. Example 3: Kyle, a 27- year- old designer with a graphics firm has had an unused health insurance policy because he has never been sick. Being recently laid off, he could continue his insurance for 18 months if he paid the premium, but decides to drop it since he thinks it not worth the money, especially given his now smaller income. He does not, however, drop collision coverage on the Prius Hybrid he just bought before he got his pink slip because the car is worth a lot and he sees fender- benders every day. 3

4 Kyle exhibits System 1 behavior by treating the likelihood of an illness as being below his threshold level of concern given his budget constraints, even though the consequences could be highly significant. Kyle does not collect any information on his likelihood of having a serious illness or an automobile accident. He views the chances of an automobile accident causing damage to his Prius as being sufficiently high that he keeps his coverage, even though the financial impact would be minor compared to a serious health problem. If Kyle were to behave in a System 2- like fashion, he would compare the expected utility of three different options: (1) purchase health insurance but not collision insurance; (2) purchase collision insurance but not health insurance; and (3) purchase neither type of insurance. To compare these three alternatives, Kyle would need to estimate the probabilities of health related illnesses and damage to his car and their financial consequences with and without insurance protection. Insurer Behavior Example 4: Prior to the terrorist attacks of September 11, 2001, insurers provided terrorism protection essentially free of charge on their property insurance policies, despite the attempted bombing of the World Trade Center in 1993, the 1995 Oklahoma City bombing and terrorist attacks throughout the world. After 9/11 most insurers refused to offer coverage against terrorism or charged extremely high premiums for it. Insurers exhibited System 1 behavior both before and after 9/11. Prior to 9/11, insurers treated the likelihood of a terrorist attack in the United States as so low that they ignored its potential consequences. After September 11 they focused on the potential claims payments from another terrorist attack without weighting these outcomes by their likelihood. As a result they felt terrorism was an uninsurable risk. System 2 behavior would have required insurers to estimate the chances of future terrorist attacks in different parts of the country and their potential consequences in order to determine what types of coverage they would offer and the prices they would have to charge so as to maximize their expected future profits based on their current portfolio of policies. They would then determine whether they would want to limit coverage in specific regions and the necessary premiums to reduce the likelihood of severe losses to an acceptable level. Example 5: Most private health insurance provides catastrophic coverage by containing a stoploss feature that sets an upper limit on the total of out of pocket payments for coinsurance, copayments, and deductibles. However, some companies plans attenuate this protection by putting an upper limit on benefits to be paid, either in a given year or before the policyholder s goes on Medicare. This limit, usually in the millions of dollars, would be reached by a very small fraction of beneficiaries in a large insurance plan. In addition, the company could buy reinsurance to cover these events. As a result, the incremental premium to remove such limits is very low less than one percent of what the insurer is currently charging. For 4

5 example, if health insurance costs $2,000 a year, then removing the upper limit would add less than $20 to the premium. And yet many insurers fail to offer this low cost added protection. If those at risk followed System 2 behavior, this kind of affordable coverage would be viewed as highly valuable and should be easy to sell. Yet it took the recently passed health reform legislation to require that all private insurance provide coverage without lifetime or other upper limits. The reasons for this gap are not fully understood, but it appears that it results from System 1 thinking by both buyers of insurance ( it will never happen to me ) and by those insurance agents ( I do not want to be the person who sold the policy that is costing our company big money ). It took Congressional action to move health insurance toward coverage consistent with System 2 thinking. A number of the major health insurers indicated that they would have retained an upper limit on benefits as part of their standard coverage if health reform had been struck down by the Supreme Court. Regulators/Politician Behavior Example 6: Insurance regulators have aided homeowners in hurricane- prone areas in Florida by keeping rates on their property insurance policies lower than they would be if private insurers were free to charge premiums that reflected risk. Following Hurricane Andrew in 1992, insurers were only allowed to raise rates gradually over the decade and were restricted from canceling existing homeowners policies. Moreover, political pressure from residents in hurricane- prone areas to reduce homeowners premiums in hurricane- prone areas led the state legislature in 2007 to form a residual market mechanism, Citizens Property Insurance Corporation, which offers premiums at highly subsidized rates, thus undercutting the private market. Today, Citizens is the largest provider of wind coverage in Florida. There have been no severe hurricanes in the state since 2005, but if Citizens suffers a severe loss from a large hurricane in the coming years, the Corporation is likely to become insolvent. In this case, Florida will have to levy a tax on its residents and request disaster assistance from the Federal government. This illustrates System 1 short- term thinking on the part of the regulators and legislators since the premium structure they have approved will lead to aggregate claims payments exceeding premiums in the long run. The strategy yields positive returns if there is no hurricane damage in Florida in the near future. Example 7: Bill and Al are politicians running for a presidential nomination in the early 2000s. They have noticed that, among its many gaps, the traditional Medicare plan fails to provide coverage for prescription drugs. There is still some, if limited, available funding in the federal budget for partial subsidies for such coverage. In line with the theory of optimal insurance for risk- averse people, Bill proposes that the coverage for middle- to high- income seniors be catastrophic coverage with an affordable deductible; the size of the deductible should be chosen so that the cost of insurance fits the funding. Al, in contrast, argues in a debate that there is a fatal flaw in Bill s plan: The trouble with your idea, he says, is that everyone will pay 5

6 some premiums for this insurance, but most people will not collect anything since most seniors drug expenses are in the hundreds- of- dollars range and hence below the deductible limit. Experts agree that Al won the debate, Bill dropped out of the race, and even though Al did not win the election, the drug coverage plan that eventually passed had a much lower deductible than in Bill s plan, then covered only 75 percent of expenses up to a limit of $2400 ( a hole in the donut ), then stopped coverage entirely until expenses totaled $5451. This design was necessary to start coverage at a relatively low value and yet meet the same target premium as in Bill s plan that had a lower catastrophic threshold. To be elected in a democracy, you must appeal to the voters, and it seems that Al was appealing to voters with System 1 thinking, whereas Bill might have hoped had he gone further in the campaign to assist them in undertaking System 2 thinking. This story suggests that automatically assuming that a real world government can and will step into correcting System 1 thinking may not necessarily be realistic. The same errors that individuals make in their own thinking can be propagated through the political system in some circumstances. These examples highlight the systematic biases and simplified decision rules that consumers and insurers exhibit in System 1 behavior and the types of System 2 thinking that would be more appropriate for them to follow. Behavior by consumers and suppliers are a principal reason why insurance is the most misunderstood industry. While the examples above are real, people often buy insurance that makes good economic sense. They buy property insurance on their homes even if they own their house outright. They buy collision insurance on their new cars. They buy life insurance if they have dependents. But some other kinds of insurance pose problems. What is different about them? As already discussed, consumers make decisions based in part on their past experience. If they have suffered or seen a significant loss, this is easily called to mind in thinking about insurance. It is likely to motivate them to purchase coverage even at premiums that might be fairly high relative to benefits. Paradoxically, insurance delivers the greatest value high benefits for low premiums exactly in cases of relatively rare events that people tend to ignore or be less aware of. So choosing to buy coverage against low- probability, high- loss events is not an easy choice for many consumers. Insurers, in contrast, are used to seeing many disasters that are rare for a given individual. A specific house is unlikely to catch on fire but quite a few homes will in an insurer s portfolio. Hence, an insurer can predict with some accuracy the magnitude of certain losses from year to year, given the law of large numbers. What causes problems for insurers is the catastrophic event, which is rare not only for each individual but also for a large group of individuals or exposures in an insurance company s book of business. Earthquakes or massive floods fall into this category: a low probability event that, should it occur, brings highly correlated (rather than independent) losses in the particular geographic area. Of course, earthquakes and massive floods occur from time to time throughout the world, but even large insurers do not cover the globe. Reinsurers can bundle these events so they are more predictable, but 6

7 even they have trouble with the truly rare catastrophic disaster like 9/11, Hurricanes Andrew (1992) and Katrina (2005) or the Japanese earthquake- tsunami- nuclear disaster of March Cases such as these lead to malfunctions and misfires in insurance decisions by buyers, sellers and regulators. It is here we find most of the problems. Dealing with Biases and Heuristics of Relevant Decision Makers We now turn to addressing the biases and simplified decision rules that characterize System 1 behavior so as to encourage processes that make the relevant tradeoffs that comprise System 2 thinking. Our focus will be on the three key actors in the insurance drama- - - consumers, insurers and regulators - - so they can work more closely together to improve individual and social welfare. Consumer Behavior The challenge in overcoming System 1 behavior by consumers is to provide them with data and information to appreciate the need for more systematic thinking. To highlight ways that this might be accomplished, consider the following heuristics and biases illustrated by the above examples: Individuals view insurance as an investment rather than as a protective measure. One way to convince them that they should celebrate not having experienced a loss is to indicate the magnitude of their losses should their house and contents be seriously damaged by a natural disaster. It would also be useful to point out that if they were uninsured they would have to use their own resources to pay for replacing these items and having to repair or rebuild their home. They should reflect on both these points before deciding whether to cancel their insurance policy because they had not collected on it for several years. Many people buy insurance voluntarily only after a disaster occurs. The event for which they were not covered, such as a flood or earthquake, becomes salient to them after suffering a loss. To correct the availability bias it may be necessary to provide these individuals with information on the chances of a future disaster causing damage to their property and the likely claims payment if this event occurs. These data enable a person make the relevant tradeoffs between the cost of insurance and its expected annual benefits. They can then make a more informed decision as to how much coverage (if any) to purchase. It is not uncommon for individuals to underestimate the likelihood and consequences of a low probability event that they have not yet experienced. Some of those at risk may decide that the likelihood of the disaster is below their threshold level of concern and hence they have no interest in undertaking care or exploring insurance purchasing. One way to convince individuals to pay attention to the risk and consider insurance is to stretch the time horizon over which it is measured. In the 1990s when seat belt usage was not required in many states, a much higher percentage of respondents to a questionnaire expressed an interest in wearing a seat belt when they were given information on the chance of their being in an auto accident during a lifetime of driving rather than on just their next trip. Property owners are more likely to insure against a 7

8 flood and pay considerably more for coverage when the likelihood of the flood is presented as greater than a 1 in 5 chance probability of experiencing at least 1 flood in the next 25 years rather than there is a 1 in 100 chance of experiencing a flood next year. Insurer Behavior Insurers, who should behave in a more rational and less unemotional way than consumers and often have statistical training for dealing with extreme events, have similar biases and heuristics. We suggest the following ways of overcoming their System 1 behavior. To counteract a tendency not to consider certain risks when pricing a policy, as insurers did with respect to terrorism prior to 9/11, insurers should be encouraged to construct worst case scenarios for those events that they feel are below their threshold level of concern. They then should estimate the likelihood of the event s occurrence and determine a premium that reflects their estimated expected loss. A similar process should be followed after a large- scale event occurs, such as the 9/11 terrorist attack, to determine whether the risk is truly uninsurable. Annual policies are a fixture when it comes to most insurance and reinsurance but there should be no reason why insurers could not also offer multi- year policies if they are free to price coverage to reflect that risk. Multi- year policies diversify the risk over time as well as across individuals, thus reducing the variance in the losses. It would be useful for insurers to compute the annual premium they would have to charge for policies where they promised to keep the price stable for several years, in order to determine whether there would be demand for coverage with premium guarantees rather than with highly variable annual premiums. A multi- year policy coupled with a long- term loan for funding risk- reducing measures may enable policyholders to reduce their premiums significantly. They would be reluctant to undertake mitigation measures if they felt that the premium would not reflect their reduced risk. Regulator Behavior Probably the hardest policy issue is constraining System 1 behavior on the parts of governmental policymakers such as insurance regulators. Regulators as elected officials perhaps focused on their reelection, restrict insurers from charging rates that reflect risk. We cannot appeal to the voters as a check on their behavior because the voters instinctive preferences are in many ways the cause of the problem; politicians who seek votes make choices that mirror the populace s preferences. But it may still be useful to think about ways of redesigning the process of political choice and regulation as something that could mitigate this problem. We need to think broadly of government rules and institutions which constrain policymakers and the policy process to be more reflective, less immediately self- serving, spur- of- the- moment, and pandering. The general name for public institutions which limit short run political actions is a constitution, though not necessarily in the form of the United States 8

9 Constitution but rather representing a prior and binding decision on checks and balances and rules of the game. When it comes to regulation and subsidy of insurance, what might be worth thinking about? There are some potential mechanical fixes that seem to work: appoint regulators as civil servants rather than being elected; require hearings and full disclosure before rendering decisions; and encourage a wide range of groups - - especially representation of the great bulk of consumers who will have to pay more if favors are done for special interests - - to be represented in some way (other than by self- styled consumer advocates who may have their own interests in mind). More substantively, it would be helpful to agree in advance on some principles of regulation, especially if a statement of those principles can be linked to disclosure of how closely they are followed. Of course, sometimes there are good reasons why it may be desirable to use insurance to redistribute resources to those who begin at lower incomes or who are more unlucky, but it might be helpful to require such regulatory decisions to be accompanied by data on who gains and who loses. In addition, there should be an explanation of why the gainers deserve to benefit from a given insurance program and (more challengingly) why others should have to pay part of the cost of protecting others. For example, requiring windstorm insurers to charge the same premiums for coastal property owners and inland property owners redistributes from the latter to the former. Requiring data to show why coastal property owners are deserving of this subsidy would be useful and would inhibit transfers to the higher income people who usually own beachfront property at the expense of the middle class. Principles of Insurance Insurance has the potential of being a very effective policy tool for dealing with risk. Those undertaking preventive or protective measures can be rewarded by having their premiums reduced. Insured individuals suffering losses receive claim payments to assist them financially. For insurance to play this dual role, guiding principles are needed so that insurers will want to market coverage, consumers will want to purchase policies and invest in risk- reduction measures, and regulators will want to implement these policies. Below we specify two guiding principles that are likely to satisfy these three stakeholders. Principle 1: Premiums reflecting risk. Insurance premiums should reflect risk to signal to individuals how healthy and safe they are, what preventive or protective measures they can undertake to reduce their vulnerability to illness and/or property losses, and whether buying insurance really reflects efficient risk spreading. Risk- based premiums should therefore also reflect the cost of capital insurers need to integrate into their pricing to assure adequate return to their investors. Principle 2: Dealing with equity and affordability issues. Any special treatment given to consumers at risk (e.g., low- income uninsured or inadequately insured individuals) should come from general public funding and not through insurance premium subsidies. Principle 3: Multi- year insurance. To overcome myopia and encourage investment in preventive or protective measures, insurers should design multi- year contracts with premiums reflecting risk. Means- tested insurance vouchers should deal with issues of equity and affordability. 9

10 We now apply these three principles to the design of property and health insurance policies that might be attractive to the three key parties: consumers, insurers and regulators. Application to Flood Insurance The National Flood Insurance Program (NFIP) is a natural candidate for applying the above three principles. Since its inception in 1968, the NFIP has expanded dramatically. In 2012 it sold over 5.5 million policies compared to 2.5 million in 1992 and provided over $1.2 trillion in coverage compared to $237 billion in With the renewal of the NFIP in July 2012 there is now an opportunity to modify the NFIP so it encourages those residing in hazard- prone areas to take steps in advance of the next disaster to reduce their losses. Rather than the habitual one- year insurance contract, individuals and business owners should have an opportunity to purchase a multi- year flood insurance contract (for example, 5 years) at a fixed annual premium that reflects the risk (Principles 1 and 3). At the end of the multi- year contract, the premium could be revised to reflect changes in the risk. Such an assessment would be undertaken by a certified panel with the relevant expertise to determine whether there have been systematic changes in the likelihood and potential consequences of water damage from flooding and hurricane storm surge to different geographical regions. To address System 1 behavior, the flood insurance policy should be tied to the property rather than the owner. If the property is sold, then the multi- year flood insurance contract would be transferred to the new owner. A principal reason for this is proposed change is that individuals tend to view insurance as an investment rather than a protective mechanism and often cancel their coverage if they haven t had a loss for several years. There is a lack of appreciation that the best return on an insurance policy is no return at all. Empirical evidence on this point with respect to flood insurance comes from an analysis of all new flood insurance policies issued by the NFIP over the period January 1, 2001, to December 31, The median length of time before these new policies lapsed was three to four years. On average, only 74 percent of new policies were still in force one year after they were purchased; after five years, only 36 percent were still in force. The lapse rate is high even after correcting for migration and does not vary much across different flood zones. In accordance with Principle 2, a new flood insurance voucher program would address issues of equity and affordability. This program would complement the strategy of risk- based premiums for all (Principle 1). Property owners currently residing in a flood- prone area who require special treatment would receive a voucher by the Federal Emergency Management Agency (FEMA) or the U.S. Department of Housing and Urban Development (HUD) as part of its budget or through special appropriation. This program would be similar to the Supplemental Nutrition Assistance Program (food stamps) and the Low Income Home Energy Assistance Program that enable millions of low- income households in the United States to meet their food and energy needs every year. The size of the voucher would be determined through a means test in much the way that distribution of food stamps is determined today. 10

11 In keeping with the concept of risk- based pricing, insurance premiums would be reduced for structures where the property owner has invested in protective measures whether or not the cost of the policy had been reduced through an insurance voucher. A piece of property whose annual expected loss was reduced by $200 through flood proofing measures would automatically have the flood insurance premium reduced by $200 from what it was in the previous year. If financial institutions or the federal government provided home improvement loans to cover the upfront costs of these measures, the homeowner will want to undertake the investment. To illustrate this point, consider a family who, due to budget constraints and a focus on short- term horizons that is characteristic of System 1 behavior, is reluctant to incur an upfront cost of $1,500 to make its home more disaster resistant. The upfront costs would loom large relative to the perceived benefits (lower premiums over the next two or three years) from adopting the measure. However, the family should logically be willing to pay the $145 annual cost of a 20- year loan (calculated here at a high 10% annual interest rate) if the annual premium reduction were larger than this amount; there would be immediate savings in the total annual (or even monthly) housing payment that covers the mortgage, insurance, and taxes. A bank would have a financial incentive to make such a home improvement loan because it would have a lower risk of catastrophic loss to the property that could lead to a mortgage default. The NFIP would have lower claims payments due to the reduced damage from a major disaster. And the general public would be less likely to have large amounts of their tax dollars going for disaster relief, as was the case with the $89 billion federal relief after the 2004 and 2005 hurricane seasons and resulting floods. A win- win- win- win situation for all! Application to Health Insurance The recent health reform legislation with respect to the roles of the public and private sectors did not give particular attention to our three principles. Existing insurance also deviates from them in important ways. What would it take to move toward the principles, and should we do so? Failure to satisfy equity and affordability considerations (Principle 2) is in many ways the most important failing of current health insurance markets, which health reform was designed to correct. Despite the large subsidies with respect to health insurance, a significant fraction of the population is uninsured. More specifically, total subsidies (including tax subsidies and direct subsidies to government insurances) already lowers the price of health insurance relative to its full cost total by more than $1 trillion in the United States, and makes up more than half of our health care spending. Medicare subsidizes health insurance for seniors and the disabled at a rate of 90 cents on the dollar. Medicaid provides free health insurance (but not for all low- income people), and the tax breaks associated with employment- based health insurance subsidize the 60 percent of the population who get private insurance this way. Yet despite these massive subsidies, 18 percent of the population is uninsured at any point in time, in some cases because they are not eligible for Medicaid or because the premiums for coverage would bite deeply into their other consumption. (However, a sizeable minority of the uninsured have large enough incomes that they could afford premiums but for various reasons 11

12 attach lower values to coverage.) Health reform leaves most of the existing subsidies intact (with only some modest tempering of the subsidy to job based insurance), but adds on hundreds of billions of dollars of subsides to insurance for poor and middle class people. At present, the principle of linking premiums to risk is satisfied for only the approximately 6 to 8% of the population that buys individual health insurance (Principle 1). Premiums for public insurances and for employment- based group insurance are not allowed to reflect risk. The good news is that high risks are much more likely than average risks to have coverage, but it is small wonder that the uninsured consist disproportionately of young low risks who might have been able to afford risk based premiums but pass on coverage at higher and unattractive rates. Health reform, now supported by the Supreme Court decision, would forbid individual insurance premiums to be based on risk, however, so there is even more movement away from Principle 1. The individual mandate is in large part an attempt to plug the holes in low risk participation caused by modified community rating, but may not be strong enough to do so effectively; even if effective, it burdens lower risks (who are often moderate income) with the cost of cross- subsidizing higher risks, rather than using income taxation or some other more equitable tax to generate funds for helping higher risks (who, incidentally, are not necessarily low income). The one principle that is honored reasonably well is the principle of multi- year premiums (Principle 3). Relatively uncommon private individual insurance must carry a provision guaranteeing renewal in the following year at premiums that are not altered based on any change in the person s risk; there is multi year coverage against risk reclassification. Employment- based group insurance provides similar protection to people who keep working but they can lose coverage at low rates if they lose their job. Public insurances are all single- period, but so heavily subsidized that year- to- year changes in risk or circumstances do not matter. What do these deviations from guiding principles imply about ways to improve health insurance markets? We note first that the failure to buy health insurance in some current markets probably does reflect System 1 thinking by a small but policy- significant group of consumers: about 3 to 5 percent of middle class people at average risk just do not seem to understand the value of health insurance for themselves and their families. The strongest evidence for this is the fraction of workers who choose no coverage even where the explicit employee premium is a tiny fraction of the full premium and the person took a job at a firm with generous benefits that are then ignored. However, even now and surely in the future under community rating, the reluctance of many other low risks to buy coverage even with the modest penalty under the mandate, is likely reflect System 2 thinking: they look ahead and correctly calculate that, at a premium that overcharges them to help higher risks, buying insurance is not personally attractive to them. If they do think ahead and consider that they might some day become a higher risk, they note that they will then pay the same premium whether they bought insurance at the time they are a lower risk. Hence they will be discouraged from buying a policy today.. Perhaps there is System 1 thinking (or just generally confused thinking) by policymakers who judge community rating to be the only way to achieve the appropriate social goal of helping out modest income high risks. There are better ways: government organized high- risk pools adequately funded by efficient and equitable general revenue taxation as a short- term solution, and mandatory coverage with 12

13 guaranteed renewability as a longer- term plan. These steps, with appropriate insurance vouchers to help lower income people at all risk levels, would lead toward a solution more consistent with our principles. Conclusions and Future Research Insurance is a potentially powerful tool for encouraging those at risk to take steps to reduce their losses in advance of a disaster but as we have seen, it requires consumers, insurers and politicians to overcome their myopia. Long- term vision is required to overcome System 1 behavior. The biggest challenge in this regard by all three groups occurs when they confront low- probability, high- consequence events, such as a catastrophic loss from a natural disaster. Before a disaster, buyers often choose to be uninsured because they ignore events below their threshold level of concern. Many then purchase coverage following a disaster because of the salience of the event but then cancel their coverage several years later if they have not suffered a loss because they view insurance as a poor investment that has failed to pay off. A major reason this behavior is not more pronounced is that institutions have emerged either spontaneously in the market or from public policies that foster the purchase of insurance. The linking of homeowners insurance to mortgages and automobile collision coverage to auto loans creates a large demand for coverage. Offering health insurance in the form of a group coverage with a tax subsidy provides a significant incentive to buy and retain coverage. Insurers also often exhibit erratic behavior they exit the market (if only temporarily) after a large loss occurs, even though they should recognize that future expected losses have hardly changed. Those that re- enter initially charge very high premiums that are difficult to justify on actuarial grounds. As the large loss recedes in time and memory, insurers often go to the other extreme by setting premiums that ignore these potentially catastrophic events because they perceive them to be unlikely. Sellers of individual health insurance often raise premiums based on poor actuarial data or fears of adverse selection that do not materialize, and are generally inept in explaining why they use the underwriting characteristics they do or why they change premiums for various risk classes. Legislators claim that individuals should be protecting themselves prior to a disaster and that they will not get federal relief after the event, but relent when the disaster is severe, particularly if the event occurs in an election year. Tropical Storm Agnes did severe damage to Pennsylvania and New York in June 1972, and Congress was quick to pass special legislation providing $5,000 forgiveness grants to those who suffered severe losses and 1% low interest loans to retire old debts. From a financial point of view, many victims were far better off with this generous package than they were prior to the disaster. Should a hurricane causing severe damage to Florida or Gulf Coast States occur in September or October 2012 it is highly likely that the U.S. Congress will respond with a generous package of relief. If buyers and sellers of insurance use decision rules that reflect System 1 behavior, what if anything should be done to change their actions? On the supply side, should regulators, rating agencies, and the public sector play a role in maintaining the availability of coverage at reasonable premiums following major disasters? On the demand side, should one endorse behaviors that reflect short- sightedness, 13

14 probability neglect, or strongly- held but incorrect beliefs? If government should sometimes step in, what are the chances it will actually do the right thing including limiting its intervention? We conclude that sometimes intervention is necessary, but are uncomfortable because there should be a more rigorous framework, not just an appeal to common sense, as a way of motivating policy. We have outlined some principles for doing that, ranging from the uncontroversial but hard- to- implement, like providing good information for buyers of more transparent insurance contracts, to more contentious advice like having premiums reflect risk supplemented by insurance vouchers for dealing with equity and affordability issues. Legislators and regulators who follow these principles need to have their bravery recognized and rewarded. Getting things right, especially at a time when insurance companies are unpopular and high- risk groups are powerful, often implies being at political risk. Insulation of regulation from political pressure, for example, by having appointed rather than elected regulators, is a step in that direction. But the most important step may be a full and frank societal discussion of the roles insurance markets should play and the behaviors we really think important to foster or alter. The insurance industry is misunderstood. Buyers of its products have a hard time comprehending what they are getting, partly because of avoidable confusion but also because risk is fundamentally a complicated concept difficult to explain in simple language. Sellers of insurance believe that they are often unfairly blamed for being the bearers (or at least the accomplices) of bad tidings. They enter the scene after a disaster and are often accused of not settling claims promptly or fairly. They compound the misunderstanding by pulling out of the market or raising premiums significantly. One of the remedies for a misunderstood industry is increasing our understanding of it, a goal of this article. The renewal of the National Flood Insurance Program in July 2012 authorized studies by the Federal Emergency Management Agency and the National Academy of Sciences to examine ways of incorporating risk- based premiums coupled with a means- tested insurance voucher, two principles discussed here and in our forthcoming book, Insurance and Behavioral Economics. The new health reform legislation addresses potential buyer myopia but may have created some additional problems because of its failure to permit risk based pricing. Flood insurance reform and health insurance reform offer an opportunity for the private and public sectors to work together in making the insurance concept a more meaningful one that it currently is and to help those who purchase coverage make more thoughtful decisions under System 2 behavior rather than System 1 heuristics and biases. 14