How Government Disables Private Disability Insurance
Wright, Robert E., Ideas on Liberty
Taxed Social Security earnings determine the level of three major types of Social Security benefits-the life annuity at the center of most discussions of Social Security, survivors' benefits, and disability benefits-available to individual working Americans at any given time. All three benefits were originally the bailiwick of privately owned and managed business firms. Those firms, called life insurance companies, remain the most efficient and just method for protecting individuals from the economic travails of dying too young (life insurance), dying too old (life annuity), or losing the ability to work (disability). The economics of disability will be discussed here.
In the late 1910s, life insurers in the United States began to offer insurance against the risk of "total" and "permanent" inability to work by offering, in return for a rationally calculated premium, periodic cash payments to life-insurance policyholders if and when they became disabled. Rather unwisely, the companies linked the amount of the payment to the face value of the policy rather than to the policyholder's current income. Predictably, during the Great Depression disability claims skyrocketed. Though not as liable to abuse as unemployment insurance, disability insurance claims are subject to fraud, misrepresentation, and ambiguity. Insurance companies suffered losses, but at the same time they learned that disability insurance will be abused unless the monthly payment is less than the policyholder's net remuneration from work. As the payment approaches or exceeds take-home pay, the policyholder will find it increasingly tempting to claim disability.
Life insurers also learned that individuals are not equally likely to suffer from a disabling illness or accident. As they learn more about the variables that increase the likelihood of disability, they develop premium rate books which ensure that each policyholder pays an actuarially sound premium based on the probability that he will become disabled. Moreover, simple business competition ensures that disability premiums tend toward their rational or natural level. If an insurer charges premiums that are too high, it makes large profits and attracts new entrants that in turn create downward pressure on premiums. If an insurer charges premiums that are too low, it suffers losses until it raises premiums or exits. Regulations and artificial barriers to entry limit the efficiency of the market to some extent, but all in all, market forces prevail and disability premiums are as rational and fair as the government allows.
In addition, life insurers have incentives to pay legitimate claims in a timely manner, to deny spurious claims, and to monitor disability beneficiaries closely. Any insurer that fails to pay legitimate claims, or that delays payment, will see its reputation suffer. Likewise, any insurer that pays fraudulent claims incites further instances of moral hazard and soon becomes unprofitable. Similarly, the profitability of insurers that do not regularly check to ensure that beneficiaries remain disabled also suffers. Insurers therefore give their claims representatives incentives to treat policyholders fairly, which means catching fakers but not begrudging the truly disabled their contractual due.
Indeed, the private system of disability is, like all free markets, equitable. Individuals can choose to go uninsured if they desire; healthy individuals who desire coverage may obtain it at a rational and competitive market price. Claimants are treated fairly; if a disagreement arises, both parties have access to objective courts of law, arbitration proceedings, or private negotiation. In borderline cases, for example, parties are free to settle the claim with a lump sum payment or a reduced level of periodic payments.
Private disability insurance became an even better bargain in the 1950s because of the rapid proliferation of "group insurance," a fringe benefit many employers offered to employees. …