Insurance – How it Works

I will start this short series of articles by discussing the basic principles of insurance and some of the problems you have with insurance schemes. So much of what I have read online and in news publications seems to miss some pretty basic points here, and that leads to a very bad policy discussion. In doing this, I am going to try to the best of my ability to be objective and just present basic facts without bringing in value judgments.

“Life is uncertain. Eat dessert first” – Ernestine Ulmer

Uncertainty and risk are the key concepts in developing an understanding of insurance. Insurance is at its heart a pooled risk program, which means that a group of people agree to share the costs of uncertain events. In any given population, there will be a certain number of adverse events that will have a negative effect, but we cannot tell in advance to whom these events will occur. When I buy a homeowner’s insurance policy, I cannot tell in advance whether my home will have a fire, or be destroyed by a tornado, or any number of other adverse events my policy covers. This is rather like gambling, in that I am paying money to get a policy on the assumption I might need it, while the company is selling the policy on the assumption I won’t, and therefor they will get to keep all those premiums I paid. How can the company do this and make a profit? They need to have very good estimates of how often they will need to pay policyholders, and use that information to set the level of premiums. This requires some very careful statistical analysis from people called actuaries. This is serious green-eye-shade stuff, and very technical. The joke about actuaries:

Q: How can you tell the difference between an actuary and a computer?

A: The computer has a personality.

This is rather unfair, though, since I have known some actuaries and they were fine people. But also very similar to accountants, about whom the same joke has been written.

But in any case, how does a profit-making company maximize its profits in this scenario? It can charge higher premiums, identify people more likely to file a claim and refuse to sell them a policy, or some combination of the two. What can stand in the way of either these approaches? Generally, if there is effective competition in any market, there is pressure against raising prices. So one policy goal might be to increase competition, and when possible that is frequently the best way to go. But an alternative is government intervention in the marketplace to either limit prices or reduce the ability to refuse coverage. Obamacare does both of these things to some degree, as we will explore.

Moral Hazard

From the early days of Insurance, in the 17th century, a problem of moral hazard was recognized. In its broadest form as applied to insurance it says that people might make decisions differently just because they have insurance. They would, in other words, engage in riskier behavior if someone else bears the costs than they would if they had bear them all. This is not the same thing as fraud. If you burn down your house just to collect the insurance money that is a crime, but not what we mean by moral hazard. Instead, think of someone who drives a little more aggressively knowing that any fender-benders will be covered by the insurance company. If you knew you would bear the whole cost, you would probably be a little more careful.

To address this problem, insurance companies typically include in their policies incentives to get the kind of behavior that reduces claims. They can be either carrots or sticks, though generally I have found the carrots to be more common. My automobile policy sends me a “Good Driver” check every year because I have not made a claim. My health insurance premium is lower because I have demonstrated healthy behaviors that reduce the chances of large claims. When there are sticks involved it usually comes in the form of limiting coverage, or even refusing it. For instance, if you were looking for a long-term care policy, but you are 65 years old, have several major illnesses, and a bad family history of illness, you should not be surprised if a company turns you down, or quotes a premium you cannot afford.

Profit vs. Non-Profit

In general I don’t think this matters all that much because any organization that wants to remain functioning needs to cover all of its costs. In insurance, this is often referred to as being actuarially sound. In its simplest terms, this means that the organization has the funds to pay all reasonably anticipated/projected costs of claims. Does adding a profit on top make a big difference? I don’t think so in general. It will probably depend on the same factors of market competition and government regulation as to whether profit becomes excessive, but even non-profit organizations face a challenge here. For example, in the United States there is a social insurance program called Social Security that is plainly an insurance program, and periodically there are concerns about whether it is actuarially sound, and when the topic turns to state and local retirement schemes (in the U.S.) there is a serious crisis because they are demonstrably unsound.

So I think pointing at profit is a red herring. And in the U.S. at least, it is a legal principle that companies are entitled to fairly pursue a profit. If government regulation places limits on this pursuit (e.g. public utilities) the law is clear that the company is entitled to a “normal profit”, and it has grounds to sue the government to preserve this. But even outside of the legal strictures, as a practical matter it is very hard to force private companies to lose money. In the U.S. that would result in the company leaving the market. In India, it caused decades of abysmal economic performance because they prevented companies that were losing money from leaving the market. One reason economics is called “the dismal science” is because it frequently tells you your ideas won’t work.

Conflicting Interests

So consumers and insurance companies have opposite interests in many ways. Consumers are most desirous of having insurance if they face large risks, and that is when companies are most likely to turn them down or quote premiums that they cannot afford. This is inherent in the nature of the system. So how can this be reconciled? There are only a few solutions given the strictures we have already examined, e.g. I am ruling out forcing companies to lose money.

  • Do nothing – Some people will get insurance, others won’t. If your daughter is born with a birth defect the company can cancel your policy. Too bad.
  • Do nothing, but mandate the Emergency Rooms need to treat people – This has been in effect for some time, and what it does is limited since Emergency Rooms only treat emergencies. You won’t get treatment for Diabetes here, but if you go into a coma they will stabilize you before putting you back on the street. Costs are shifted onto the government and onto people with insurance policies in varying proportions. Hospitals have to cover their costs as well.
  • Government help for the worst off – Similar to the Do Nothing policy, but in this case the government steps in to make sure you still have coverage after your daughter is born with a birth defect. This means the cost is shifted onto the tax payers.
  • Government regulated insurance markets with strict mandates – This is the Obamacare approach. Companies cannot, for instance, refuse you coverage, and certain medical treatments must be covered, in some cases free of charge to the consumer (e.g. certain preventive care items). But the insurance is offered by private companies who do get to make a profit, and if they cannot make a profit they can leave this system. and care is provided by private organizations (doctors and hospitals)
  • Full Government provision of health coverage, but with private providers – This is Medicare (in the U.S.). Every American is eligible at age 65 to sign up. Costs are covered through a combination of premiums paid beginning when you reach age 65, and by tax payments collected throughout your working life, which are essentially prepaid insurance.
  • Full Government provision of all health care – This is the European model, though the details vary among countries. Providers (doctors and hospitals) are no longer private, but employees of the government and receive the usual salary and benefits.

Now, there can be variations in these models. Many European countries have a complete Government health care system, but allow private practioners to sell services outside of the system. But this is a starting point for understanding what the options are, and let’s us move eventually to the topic of the trade-offs involved in different solutions.


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