"Slarrow" refers to the "slings and arrows of outrageous fortune" from Hamlet's soliloquy. Here are the chronicles of such darts and whatever attempt there may be to take arms against such a sea of troubles.

Location: Ozarks, United States

Friday, August 28, 2009

How Insurance Works

I wanted to write a bit more on how insurance works and why proposals that sound great may not be all that good in reality. Let's start with a basic, stripped down model of what insurance is like.

Medical insurance works essentially like this. I'm sitting in a room (call it the Alpha room) with 99 other people, and a guy walks up on stage. He tells us that 5 of us are expected to get the dreaded Disease X, and it will cost $200,000 to treat. Problem is, we don't know which 5 will get it. To guard against that, he proposes that we pool our money. We'll each give him $750 a year for 20 years. That comes to $1.5 million from our group against $1 million of expected expenses. If I don't get Disease X, I paid $15,000 for nothing (except peace of mind.) If I do get Disease X, though, that $15K will seem like nothing compared to the $200K I would have been out.

That's basically how all insurance works. I'm paying to guard myself against the risk of financial ruin if Bad Event Gamma (or BEG) happens. Medical insurance is for bad events that require medical care; for auto insurance, a Bad Event Gamma is a car crash or a tree that falls on your new car and smashes the windshield (happened to me last week.) House insurance covers Bad Event Gammas like fires and tornadoes and lightning strikes (had one of those two years ago, in fact.) For life insurance, the BEG is simple: you die. (It should be called "death insurance", really. Phrase doesn't market test well, though.)

Now, where does the money to pay me come from should I "get lucky" (ha) and have to use my insurance? It comes from other people just like me who are guarding against the same risk. But here's the trillion-dollar point: it doesn't come from the insurance company. They collect it and keep it and pay it out, but they don't produce it. It gets produced by other guys like me who are making the same deal because we're all in the same room.

Now, the next room over (Beta room), there's another 100 people, and their speaker is telling them that 10 of them are likely to get dreaded Disease X, and he wants them to pay $1500 a year for 20 years. That's $3 million of cash against $2 million of expected expenses.

(Quick digression: why the big overcharge--those "huge profits" everybody always blames the insurance companies for? Mostly timing. The point of insurance is to have cash on hand when you need it, and you don't know specifically when you'll need it. If you personally had the cash on hand to reasonably deal with those unexpected expenses, then you wouldn't need insurance.)

Finally, in the last room in the corridor, there's 100 people who already have dreaded Disease X. That rooms represents $20 million in medical expenses. Right now, there isn't a guy in there telling them what they ought to pay per year. It's pointless because there's not $20 million to be produced out of that room. (That's the pre-existing condition room; we'll call it Delta.)

Now, this is the nice, clean version of insurance and how it works. But of course, in real life, this is a lot dirtier. Here's some of what happens (and what gets proposed).

a) They open the doors between Alpha and Beta and form one big room. Now the expected expense is $3 million, so they want to collect $4.5 million, which boils down to $1125 per year for 20 years from each of us. All the folks from room Beta are thrilled; their chances are still the same (that's why they were in Beta), but their costs just went down. I'm ticked off because my chances are the same but my costs went up to give those Beta blockheads a bonus.

b) They pry open a curtain and sneak 5 folks from room Delta into our mix (and they'll look for Epsilon, Theta, Iota, etc to sneak in some of the rest.) Hey, there's another $1 million of cost that entered the room. That either cuts the "profit" cushion down from $1.5 million to $500K (thereby raising the risk the insurance company won't have money to pay my expenses when I need them which was the whole point of entering the room), or it means that the 200 of us already there pony up another $250 a year. Now the Beta group is grumbling a bit, and I'm really feeling ripped off since my $750 per year has now jumped to $1375, and my circumstances haven't changed any (including my income.)

c) Of course, they really don't sell insurance based on dreaded Disease X (unless it's a specialty policy like AFLAC cancer coverage.) They sell it to cover a range of medical care, and the hope is that it'll basically work out like my oversimplified scenario. But in truth, I'm in a room with a guy (Bob) who will consume $25,000 in medical care without ever getting dreaded Disease X where I might consume $5,000 worth. I've "lost" $10K, and Bob has "made" $10K. I find out, decide that stinks and that I hate Bob, and begin consuming more medical care than I would have otherwise (and "get my money's worth", you know) so Bob doesn't make out better than I do (the freeloading punk.) That cuts into the buffer, and it's either increase the charge to restore the buffer (just in case dreaded Disease X shows up) or lose that buffer and have a whole lot of people go bankrupt because the piggy bank was empty when they needed it the most.

Now, does this little scenario solve any of the medical insurance problems that crop up? Of course not, and it's not meant to. It's just meant to be a useful illustration to show where all the pieces go without a lot of jargon that tends to confuse people. Finally, it's designed to once again reiterate the point that when you use medical insurance to pay for medical care, you're paying with other people's money. Don't be surprised, then, if they might have an opinion on that.

Couple of Medical Insurance Thoughts

I posted the following as a comment in response to Ron Rosenbaum's piece on PJMedia.

Two factors to keep in mind during all of this, though.

First, whether it’s an insurance company or a government panel, you’re asking other people to pay for either (a) your extended life (or, strictly speaking, your postponed death) or (b) your improved life. If your benefit is coming out of someone else’s hide, they have a legitimate right to have a say in that. I don’t see any way of getting around that. What I think is important, though, is that if that body says no, you have somewhere else to go. Ideally that’s a competing insurance company with whom you can make an independent deal, and if there are legal problems in the way, then let’s address those with medical insurance reform. The concern about government death panels in particular is the prospect of no appeal (the combination of cost-cutting authority with single-payer/public option monopoly that folks fear.) That’s ultimately the impetus behind conservative distrust of liberal universal health care options: that in order to serve everyone, the government must become strong enough to have the power of life and death over all. There’s still no escape from well-intentioned totalitarianism.

Second, contrary to repeated claims, the cost of medical care will not bankrupt the country. We the people always have the option our forebears did: we can do without if we can’t afford it. That will probably mean more suffering and earlier death, but we all owe the world a death anyway. Perhaps we would benefit morally and spiritually from such knowledge, perhaps we would suffer, but it would be in the hands of each of us. What can happen, though, is that the cost of medical care could bankrupt the government, and that can turn our current lives into a misery which we cannot control. Death and taxes are supposed to be the two universals, but I am not eager to see a day in which death is embraced to escape taxes.

A couple more thoughts: there is a tremendous imprecision of terminology that's complicating these issues even more. "Health care" is personal and vast and must be done by the individual who takes care of his own health. That's brushing your teeth and eating right and exercising and all the rest, and some of it may not matter a bit because of genetics. (Incidentally, the only way to really get everyone the "proper" health care, it seems to me, must involve totalitarianism. That's my problem with the competing worldview on "health care".)

"Medical care" is what doctors and nurses and dentists provide. That's where the market forces are ideally working to provide people the services they desire. Each player in that market has costs they have to cover, services they want to consume, and profits they want to make. These folks are typically part of people's lives in three types of situations: (1) as part of individually determined "health care" (like dentist visits every six months), (2) when professional expertise is needed (condition must be diagnosed or treated with resources/skill beyond the layman's level), and (3) in accident/emergency situations that aren't foreseen and require immediate treatment (broken arm, car accident, unexpected heart attack, etc.)

"Medical insurance" is the major tool people use to pay for medical care. First and foremost, I think it needs to be clear that when I use my medical insurance to pay for a procedure, I'm buying a benefit with other people's money. That's what insurance is. (More info about this situation in the next post.) Part of the problem is that medical insurance makes the most sense when applied to categories 2 and 3 of medical care. However, most insurance these days is also used for category 1 types of medical care, and that's where all the structures and rules fall apart. But that's the next post.