Why do people buy insurance? On the one hand, the act of purchasing insurance is an utterly rational act, dependent on the uniquely human ability to ponder counterfactuals in the distant future. What if my a fire destroyed my house? What if my new car got totaled? What if I get cancer and require expensive medical treatments? We take this cognitive skill for granted, but it’s actually profoundly rare.
And yet, the desire to purchase insurance is also influenced by deeply irrational forces, and the peculiar ways in which our emotions help us assess risks. The passionate nature of risk – and the ways in which our passions lead to misperceptions – shouldn’t be too surprising. Look, for instance, at the very common fear of flying: More than 30 percent of people admit to being “scared or very scared” whenever they board a plane. And yet, according to the National Transportation Safety Board, flying on a commercial jetliner has a fatality rate of 0.04 per one hundred million passenger miles. In contrast, driving has a fatality rate of 0.86. This means that the most dangerous part of traveling on a commercial flight is the drive to the airport.
What does this have to do with insurance? Let’s consider health insurance, which is the insurance debate du jour. America is that rare developed nation that 1) doesn’t provide universal health insurance and 2) doesn’t require individuals to purchase health insurance. (Massachusetts is the rare exception.) In other words, we trust ourselves to make the right decision when it comes to health insurance. The end result is that lots of healthy young people opt out of the system, choosing to accept the risk of illness in exchange for not having to pay some insanely expensive premiums.
It’s easy to imagine a world in which such calculations were reasonable, rooted in some statistical equations that, under certain circumstances, show that purchasing health insurance is a bad idea. (I’m thinking here of warranties for electronic products, which are almost always overpriced.) Alas, we don’t live in such a reasonable world; our perceptions of health risks shouldn’t be trusted.
I’m going to focus on just one of the myriad biases that warp our health insurance decisions: the availability heuristic. This is the obvious idea (at least it seems obvious in retrospect) that events which are more easily brought to mind also seem more likely. The bias was first demonstrated by Kahneman and Tversky in their seminal 1974 Science paper:
Suppose one samples a word (of three letters or more) at random from an English text. Is it more likely that the word starts with r or that r is the third letter? People approach this problem by recalling words that begin with r (road) and words that have r in the third position (car) and assess the relatively frequency by the ease with which the words of the two types come to mind. Because it is much easier to search for words by their first letter than by their third letter, most people judge words that begin with a given consonant to be more numerous than words in which the same consonant appears in the third position. They do so even for consonants, such as r or k, that are more frequent in the third position than in the first.
What does this have to do with health insurance? I’d argue that the sheer banality of most illnesses means that healthy people underestimate the likelihood of getting sick, just like subjects underestimating the frequency of consonants in the third position. We don’t think about bunions or torn ligaments or strep throat unless, god forbid, the affliction happens to us. Unlike a plane accident or a shark attack, there is nothing newsworthy about ordinary suffering – kidney stones don’t make the front page or the 11 o’clock news. (I’ve got several friends who purchased extended warranties for their computers but don’t have health insurance. I’d argue that this irrational contradiction occurs for two reasons: 1) they are overvaluing their computer at the time of purchase, thanks to the endowment effect and 2) it’s easier for them to imagine a broken computer than it is to imagine a broken body part.) Furthermore, there is something inherently unfathomable about pain unless the pain is ours; sickness is the same way. The end result is that when we’re healthy we routinely underestimate the likelihood of not being healthy, of needing an expensive medical treatment that we can’t afford. The bleak reality of life, however, is that illness isn’t an outlier – everybody gets sick.
It should be noted, of course, that society requires insurance for drivers precisely because it doesn’t trust us to make the right decision. We all think we’re above average drivers, so of course we won’t get into an accident. But then we do and it’s too late. I’m increasingly coming to believe that health insurance is the same way, and that we need society to save us from our own blinkered views of the future.
And if you’re interested in the biases that influence the health care political debate, check out this typically excellent column by James Surowiecki.