Reputation and Insurance

Bryan Caplan offers an interesting take on the debate over health insurers and their allegedly bad incentives:

Here's an argument even I've found seductively appealing:

The problem with free-market health insurance is that if a customer develops a truly serious health problem, his insurance company will try very hard to weasel out of the contract.  At best they'll deliberately give poor service to the people who need it most, because they know that none of their competitors want to poach customers with serious pre-existing conditions.  At worst, they'll claim that you broke the contract somehow, and hope you die before your lawsuit gets to a jury.
It seems plausible, no?  If your condition is truly catastrophic, won't profit-maximizing health insurers struggle to "contain their costs" at your expense?

The problem with this argument is that it proves far too much.  The same argument applies to life insurance and home insurance.  You dutifully pay your premiums for years.  Then you suddenly die, or your house burns down.  What's a profit-maximizing insurer to do?  Say you died or the house burned down because you were smoking in bed, of course!  Can you prove otherwise?

Yet in practice, people almost never complain about disingenuous disputes with life or home insurers.  Why not?  The obvious explanation is that life or home insurance companies that shirk their responsibilities hurt their reputation.  It might seem profitable to reject expensive claims, but in the long-run, an insurance company that mistreats its expensive customers is going to have trouble attracting any customers at all.  After all, what's the point of buying insurance from a company that won't pay when you need it most?

So why would the reputational argument be any less convincing for health insurance?  I wouldn't choose an insurer that was known to abuse or abandon its sickest customers.  Would you?  And why would word of mouth, advertising, and other conduits of reputation be less potent here than in other lines of insurance?

This is interesting, but I'm not sure it's quite right.  I had originally thought that the main problem was that you need ongoing interaction with the company--once you've gotten cancer, you're effectively unable to obtain private insurance. But I think the real problem is monitoring.  The payouts for a life or homeowner's insurance policy are for discreet and generally agreed upon events:  your house burns down, you die.  There is occasional fraud on the customer side, and occasional chiseling on the insurance company side, particularly when they're planning to exit the business (witness the arguments over whether Katrina damage was from wind or water, since only one of the two was an insured event.)  But mostly firms pay out because we know, and they know, what has occcurred and what the appropriate remedy is.  Moreover, the payout is roughly known in advance.

But in health care, it's hard to measure inputs, much less outcomes.  Difficult-to-diagnose conditions abound.  Once you are diagnosed, deciding what constitutes an acceptable standard of care from your insurance company is fraught.  Even if you agree, people frequently get the legislature, or the newspapers, to intervene on their behalf.  New treatments are invented, old ones are found to be ineffective.  You pretty much can't write a solid contract.  So it's not really surprising that costs tend to billow out of control, and people get angry when their insurers try to rein them in.