Insurance 101

Because we are about to enter a new round of debates about health insurance, we need to clarify basic insurance concepts.  In the beginning of the industry, insurance was a bet you made with a company which bet you didn’t mind losing.  For example.  If you buy life insurance, you are betting that you will die in the coming year and the insurance company is betting that you will live.  Most of us are quite willing to lose that bet.  If you know that you are going to die in the coming year, it,s not so much a wager any more. Which is why insurance companies require physicals and have suicide exclusions.

But, you get it, its a wager.  And the model works well so long as  the outcome is genuinely unknown to both parties and so long as it is a wager that we genuinely want to lose.

Problems develop when one side has superior knowledge.  From the insurance company perspective problems develop when the customer has better knowledge than the insurance company.  For example– there is a type of insurance called flood insurance.  Pretty much, only the federal government provides it these days.  The problem with flood insurance is that people who live in areas prone to flooding tend to know that and insurance companies may not have the detailed knowledge.  But the real reason only the federal government provides the insurance is that flood insurance that reflects the full cost is really expensive.  Take my case.  I live about 2 miles from a flood plain.  But I live on top of a hill that is about 100 feet higher than the flood plain.  The federal government wants $900 a year from me for flood insurance.  Are they nuts?  If my house gets flooded all of Southern California will be washing in to the sea.  But people who live in houses, part of which rest on piles and hang out over the surf in Malibu will be getting a real bargain at that price.   So what happens is that people who know that they are at risk buy the insurance, forcing the price up, which results in people who have a lower risk dropping out.

Health insurance started out as hospital insurance and it more or less worked okay because most people don’t want to be hospitalized.  But as it developed over the  years health insurance morphed into a pre-paid care plan.  The prepaid care plan brought a different reason for insurance.  It was no longer a wager but a group buying effort.  That is, the big insurance companies could negotiate really low rates with health care providers like doctors and hospitals because they could help the providers expand their customer base.  Sort of like, merchants are mostly willing to take VISA and Mastercard, even though they have to pay a fee everytime a customer swipes the card, because they can expand their sales sufficiently to make up for the fee.  In fact, big insurance companies sometimes pay less than half of what a bill from a medical care provider asks for.

The other problem with medical insurance is that letting people pick their own providers is sort of like trying to sell all cars for the same price.  Naturally, if a Cadillac costs the same as a Chevy, most people are going to pick the Cadillac.  Some fee for service medical insurance plans are like that.They charge everyone the same price for insurance but some members of the plan like to buy very high priced medical care and lots of it.  If you are a Chevy person, you are going to get tired of paying for other people’s Cadillacs and decide to look elsewhere to get  your car.

The other big problem with medical insurance is that a lot of the care it pays for is sort of optional.  Like yearly or biennial checkups.  It may be a good idea to have them, but there is not a lot of evidence that they prevent a lot of deaths.  But, sort of like getting the roast beef at the buffet, if it doesn’t cost extra, well, of course you are going to get it.   When we don’t have to pay the cost, we act in ways that are not cost conscious.

Another thing we need to remember about insurance is what are called “transaction costs”.  Transaction costs are the costs of processing a claim.  That includes everything from the billing clerk at the doctor’s office to the postage stamp on the envelope used to send in the claim form.  It includes huge offices where millions of forms are processed and computers which process claims that are electronically submitted.  Just processing claims is a huge industry in the United States.  Transaction costs are real and sometimes substantial.  This is why you can get a significant reduction in your property or comprehensive insurance by simply agreeing to a substantial deductible on your policy.  Certain parts of processing a claim are fixed and are not proportional to the size of the claim.  Sort of like buying a cup of coffee at a restaurant.  The first cup, which includes the cost of bringing the cup to the table. removing it later and washing it, make the first cup of coffee the most expensive.  Refills are cheaper because you are using the same cup. So, people like me question whether it makes sense to have drug coverage that covers prescriptions I can buy myself for $4.00 ( some 300 generics are priced like that at Target, Walmart and Walgreen).

And the most important thing to remember about Health Insurance is that its insurance, its not health care. Health care is what you get when you see a doctor or go to the hospital.  Insurance is one way of paying for it.  The debate we have should question whether it is the most efficient and effective way to pay for it.