On Risk:
Insurance - all insurance - is based on the principle of risk. It is basically paying a smaller, known cost in exchange for the promise to offset the risk of an unexpected larger one. Insurance companies employ specially trained math geeks, called Actuaries, to predict the level of risk their customers present and calculate the cost. As long as a company correctly predicts that risk and prices accordingly, they can stay in business.
It's important to pause here. If the risk of something is 100% certain (like a 100 year old man buying a life insurance policy), that doesn't work in an insurance model. Insurance, above all, is basically betting that you won't need it for more than you pay in. It's the peace of mind that a fixed predictable cost is better than getting hit with a big unexpected expense, but the company is betting that it won't come to that.
On Claims:
Insurance companies, using their actuaries, predict the likelihood and cost of people they insure filing claims under their policy. Companies never expect to pay EVERYTHING on every policy for every policyholder all at once. There's a fairly predictable volume. Companies have to have the cash resources on hand to pay those claims as they come in. But they also have to reserve cash in some form for a catastrophic event. So, part of the money that comes in from premiums goes back out the door right away, and part of it goes to "loss reserving". Think of 100-year storms or massive flu outbreaks. You can't predict them specifically, but you know, eventually, you'll have to endure one.
On Pricing:
Here's where it gets interesting. If you have a pretty good idea of the level of risk and the amount of claims you need to cover, then you've got the broad strokes of how much you need to charge. If you wanted to, you could just take all of projected costs and divide them evenly across all customers. But that would mean some people - the people with the lowest risk - would be paying more than their "fair share".
If you charge your best customers more than you have to, they're going to go somewhere else. So, companies use "tiering" to break up rates into blocks, based on their risk profile. For each individual person, the price is wrong, but as a group, the math works out. The flip side is that there are some customers that will never pay enough in premium to cover their probable costs to the company, and tiered pricing has the double impact of keeping costs low to the "good" customers and financially encouraging "bad" customers to do business elsewhere.
This may sound a little heartless, but the quickest way for an insurance company to become financially unstable is to take on too many high-risk policies or to lose its low-risk customer base. And a company that is financially unstable can't pay its claims anymore. So, it's very important for companies to maintain a healthy and balanced total book of business. If they don't, they can't keep their promises to the customers they have. Each company has to compete for those same precious low-risk customers, so price competitiveness is extremely important.
Cost-savings Tools:
Insurance companies have a few other means at their disposal to help balance the books. The details are pretty complex, but they fit into three basic buckets: controlling what's covered, controlling how much is coverable, and controlling who is covered.
- What's covered: most policies specify exactly the sorts of things they will pay out for. We call these "named perils". This makes it easier to predict the total likely claims. Companies can also offer "cafeteria style" policies, where you just pick the coverages most important to you.
- How much is covered: There are two mechanisms here, caps and deductibles. Caps limit the total amount paid out for a type of claim or over the life of the policy. Deductibles, on the other hand, let policyholders take on some level of the risk in exchange for lower costs. Deductibles are really useful for limiting the kinds of small claims that can nickel and dime a company to bankruptcy and are much harder to predict.
- Who is covered: Like I said earlier, selling a 100-year old man a life insurance policy is a sure loser. The policyholder is never going to pay enough in premium to offset the benefit, and that means other policyholders will have to make up the difference.
On High Risk Pools:
High risk customers are nothing new to insurance and not unique to healthcare. People who have been convicted of a DUI, but still have a license to drive are a special risk. People who live in coastal Florida are a whole lot more likely to have their rooftop ripped off than people living in Arizona or even 50 miles inland. These bands of extreme risk are things that insurance companies would rather not deal with, but states usually require companies who want to do business to take on at least a portion of these customers as a condition of their license. They usually also have to pay into a central pool of money, managed by the state, called reinsurance, to cover the general cost of exposure to all companies taking on these special risks. In the worst cases, state-run agencies can be the last resort for coverage, because private companies simply can't make responsible choices in these scenarios without jeopardizing their ability to pay their mainstream customers' claims.
On Gimmicks:
A lot of lip service has been given to a few shiny objects that will supposedly make things better. Two of them are "selling across state lines" and tort reform. These could get a whole post of their own, but here is a short version of why they won't actually help.
Most insurers already operate in multiple states, many nation-wide. They already balance profit and loss across their whole portfolio. There is nothing that says a company has to isolate each risk pool and balance the books at a state level. And, even if that was the case, it would only make a difference if the "other" state was a lot healthier than "your" state. That doesn't really happen. And then, the people picking up your share of the costs would be very unhappy. So that's not a thing.
A "tort" is a liability lawsuit. Lawyers don't sue people, they sue companies, because companies have a lot more money. A judge could award a million dollar fine against me and it would do the plaintiff no good, because I simply don't have the money to pay it. Lawyers sue companies. Tort reform is about limiting the amount a company can be sued for. That sounds great for companies, but if you're the plaintiff suing for damages, you probably don't want that to happen. But this is why insurance companies put limits on their policies. Those limits don't protect you, they protect the insurance companies from tort lawyers. So, again, tort reform isn't going to make a meaningful difference in the cost of insurance.
Health Insurance, Specifically:
If you take a moment to consider my previous points, it quickly becomes obvious that health care is a special animal. First of all, healthcare, unlike a car accident or a house fire, is something you WANT to happen. It's not just a matter of predicting whether or not you will get sick or injured. Routine care is both expected and necessary. So, that challenges risk models right away. Secondly, health crises, unlike a house fire, are normally long-term events, requiring progressively more expensive care as time goes on. Third, lower income is a key predictable risk factor of poorer health. There is a clear correlation between income and conditions and risk factors for chronic disease. So the people who are least able to afford it are most likely to be a higher risk and require a higher premium. And, fourth, those all-important low-risk customers that are the anchor of financial stability for any insurance company are the least likely to see the need to pay for coverage, making it very difficult to re-balance costs.
All of these factors make healthcare as an insurance model especially challenging. It's also why the individual mandate imposed by the Affordable Care Act (Obamacare) was so important. The health of the whole portfolio is guaranteed by ensuring low-risk customers are built into the model.
Let's do the math:
Say the total cost of health care for Arizona is $10 Billion a year (I'm making this up). With six million Arizonans, that's about $1,650 per person, per year in risk / cost. Using tiering, 80% of your risk is in the top 20% of your pool. Their "fair share" is $66,000. That's 133% of the median Arizonan household income. Hello bankruptcy! Do we just write off coverage 20% of the population? Or put them into high risk pools? Either way, the money has to come from somewhere. Hospitals and insurance companies will continue to incur the costs. And you can be sure they will be passed back on to you, either in the form of premiums or, if through government subsidies, taxes.
But even in the lower risk tiers, at the lower income levels, the costs become prohibitive. $2,500 a year may not feel like much to someone making $80-$100k in salary. But to a person making minimum wage, that's 13% of their income.
As with anything, the devil is in the details. And our personal health and that of our loved ones is an emotional strain as much as a financial one. Still, these principles of insurance hold true, regardless.
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