Later this week I’ll be doing a post on the PPACA, or as it’s more commonly known, Obamacare. The arguments I will be laying out in that post will be simple, if somewhat depressing:
- Despite what you may have heard from the left, the health-insurance crisis that led to the passage of Obamacare was not the nation’s poor being uninsured. Despite what you may have heard from the right, the nation’s healthcare system was not sustainable, because the way that system is primarily funded had been in the process of radically changing to something different than what it had been for decades.
- Despite its good intentions, Obamacare will not solve the actual crisis it was originally meant to solve. This is because it was largely diverted to tackle the problems that were easy to sell politically, rather than the larger problems that were more difficult to discuss.
- Our healthcare system is going to change radically over the next 10-20 years — and it will change regardless of whether Obamacare stands or is overturned. Despite what politicians of all stripes may say, there are only a limited number of directions we can go — and though each direction has benefits, each will also require sacrifices of some sort that we, collectively, would prefer not to make.
- We would be better off acknowledging the change that’s coming now, and begin to have a discussion about which sacrifices we as a nation wish to make. Otherwise, those changes will happen without our having input, and we may very much dislike what we end up with.
That’s going to make for a long enough post as it is. However, it won’t really be possible to discuss what needs to be discussed in that post without referencing some universal insurance and risk management concepts. As it is my experience that most people don’t understand the mechanisms by which insurance works, I am making this preliminary post to explain some of the major concepts I will be referring to later this week.
Feel free to read the explanations below now, or wait until they pop up in the upcoming Obamacare discussion. (Or, simply memorize these concepts and talk about them at parties! It’s a great way to get people to leave you alone.)
This term makes it sound like something nefarious is afoot. But in fact, an insurance scheme is simply the model you use for any particular insurance product that makes it (hopefully) work.
Law of Indemnity
The law of indemnity states that insurance can only be used to put you in a similar financial position as you were prior to suffering a financial loss. You cannot gain, profit, or collect other possibly deserved payments (e.g.: pain and suffering compensation) from an insurance policy.
How important is the Law of Indemnity? Pretty damn important: More than any other factor, the global economic meltdown of 2008 was due to laws allowing AIG and large, blue chip companies to legally create an insurance scheme that subverted this law.
Law of Large Numbers
Simply put, the Law of Large Numbers states that the accuracy of loss predictions increases as your pool of risk increases.
For example: If you have a dry-walling company with five employees, an insurance actuary will have absolutely no idea if any of those employees will have a work related injury in the coming year, let alone what type of injury they might suffer. If, on the other hand, you have 100,000 dry-walling companies with over a million collective employees, that same actuary can make a startlingly accurate prediction of how many employees will be injured, the number of different types of injuries that will occur, and the total cost to treat all of these injuries.
Because of this, as a pool of risk becomes larger, the amount of premium an insurer can charge and still remain solvent decreases, because there is less need to fund for uncertainty.
Law of Adverse Selection:
The Law of Adverse Selection states that those individuals more likely to sustain a financial loss are the ones more likely to purchase insurance for that loss. For example, an 80 year-old man suffering from leukemia will always be more likely to want to purchase a $1,000,000 life insurance policy than a perfectly healthy 20 year-old man, regardless of premium cost.
Because of this, over time an insurance scheme will always attract those people with greater risk, which will drive up per-capita losses, which will drive up premium, which will make those less likely to have a loss even less likely to voluntarily pay premium, etc., etc. Eventually, the insurance scheme will collapse – either because the insurer will not have been able to collect sufficient premiums to pay for losses, or because no one will be willing to pay the premiums required to fund losses.
There are two ways that an insurance scheme can get around the Law of Adverse Selection:
The first is to create a scheme that is largely designed to not have to pay claims. The best example of this is non-group term life insurance. That 80-year old man in the example above? He simply isn’t allowed to buy life insurance. (Or if he is, it will be at a premium that will be as large or larger than the death benefit). The same applies to a person with an overly dangerous occupation, or who participates in overly dangerous hobbies or lifestyles. Please do not misunderstand — life insurers do pay valid claims. (They pay them faster and with less hassle than every other kind of insurance, in fact.) It’s just that they go out of their way to make sure that they almost never have to pay anybody anything by not accepting anyone that might actually require to be a paid benefit into their pools. This is why up to 70 cents of every premium dollar you just spent on your new life insurance policy goes to the salesman that got you to sign on the dotted line, and not into the pool.
The second way around the Law of Adverse Selection is forced participation, which takes away the option for those with fewer losses to refrain from purchasing insurance. Traditionally there are three methods of forcing participation into a risk pool. The first method is by governmental decree. Examples of this type of forced participation include workers compensation, auto liability, commercial construction liability, and medical malpractice. The second method is forced participation through private third-party contract. The most obvious example of this is home insurance, which your mortgage company forces you to purchase as a condition of loaning you money. The third method is forced participation due to a third party unitarily purchasing the insurance on your behalf. Think: employer paid health, dental and disability insurance.
Pre-Existing Condition Exclusion
Up until recently with health insurance, this was a universal clause with any insurance contract. Without some type of forced membership, an insurance scheme cannot survive without this exclusion. After all, why pay premiums for a loss that might happen if you can simply wait until a loss does occur, and pay the premium then? Eventually, this leads to schemes where only people who have had losses wish to participate in the scheme, and premiums become larger than the cost of loss. (See Law of Adverse Selection, above)
Bi-Lateral Benefit Scheme
This is simply an insurance contract that is specifically designed to provide equal benefit to two adversarial positions. The most common bi-lateral benefit scheme is workers compensation.
People tend to think of workers comp as something your employer buys so you will be taken care of if you get hurt on the job. In fact, workers comp is a legal compromise between labor and management: Workers are assured payment of medical bills and a percentage of lost wages should they be injured on the job, even if that injury is directly and solely the injured worker’s fault. In exchange, that worker is not allowed to sue their employer if they are injured, even if the injury was the employer’s fault – and even if the workers comp benefit does not make the injured employee whole financially.
A subrogation clause is part of almost every kind of insurance contract. It allows the insurer to sue a third party that may have been responsible for your loss in order to recoup some or all of the claim payments.
Health insurance policies do not have a standard subrogation clause, as health insurers do not typically sue third parties to pay for your medical costs — even if those third parties are directly responsible for your illness or injuries.
Many insurance schemes collect premiums and hold on to those monies for extended periods of time, until such time as a claim is made. Life insurance is a good example of this, as is reinsurance. (My experience is that this is the way most people think all insurance is handled.)
Health insurance and workers compensation, however, are pass-through systems. In a pass-through system, the insurer has a fairly accurate idea what amount of cash will be needed to pay claims over the course of a year, will add 2-4% on top of that for their own expenses/profit, and will pay out dollars just as soon as they collect them. If their predictions are off, they make immediate adjustments upon contract renewal to compensate. The purpose of a pass-through system is not to amass premium dollars and then keep as much as possible; the purpose is to fund a fully functioning healthcare system on an on-going basis and make a couple of points off the top.