"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.