Insurance 101

I read an article written by several highly respected people in economics and health care published in The Wall Street Journal today on several aspects of the health care reform that I have thought a fair amount about. I quite agree with what they wrote and recommend reading it. I want to expand on some of the things addressed there and talk about insurance principles that are pertinent to the discussion on health care reform.

I realize this is kind of a long post. It has taken me several hours to write it. I think if you read through the whole thing it will be worth your while. First I'll talk about how insurance works (really basically); then I'll talk about policies that are currently being debated and some of their implications. Hopefully that doesn’t make you stop reading now.

How Insurance Works
No matter what kind of insurance you are talking about, you are talking about protection from some kind of risk. Insurance companies want to sell you protection from that risk for some price. The way they do that is by pooling lots of people with risk together and then doing a lot of statistics to calculate how much you have to charge people to cover the costs. I could talk about this generally, but I think it will be easier to follow with a more concrete (though very simplified) example. If you hate numbers, just skim over the details in the next few paragraphs and get the basic idea.

Let's say that there is a company that wants to insure against fire damage for houses. They expect to sell insurance to 10,000 people. Now for simplicity, let’s assume that every house is worth $200,000 so we're talking about $2 trillion dollars in property. The company does a whole lot of research and determines that on average in a given year 5 houses catch on fire: 3 totally burn down and have to be replaced (at a cost of $200,000) and 2 only burn partway and it takes $100,000 to repair them. This means that they expect to pay $800,000 every year. In addition to that, they have to pay the actuary who did all the calculations and the salesman that went around selling. Let's say that adds up to be $200,000. So their yearly expenses are expected to be $1 million. They take this number and divide it by the number of people that buy insurance to get the premium:

So they decide to charge $100 per year to each person they sell insurance to. Then as the year goes on they use all of the insurance premiums to pay for the houses that catch on fire.

Now let’s say they do some more research. They find out that houses with fireplaces catch fire way more often than those without. In fact, of the $800,000 they pay for houses that catch fire, $600,000 of it comes from houses with fireplaces. So they start adding a question on their paperwork and ask people if they have a fireplace. They find out that half of them have fireplaces, so they run some calculations:

Based on those calculations, they start charging those with fireplaces $140 and those without $60 in premiums. Then they still get the same amount of money and are still able to pay for all of the houses that catch fire.

Now you probably wonder why the company bothers to charge two different rates: they do it so that they are competitive. Suppose they didn't but their competition did. Then all those without fireplaces would go get insurance elsewhere because they can get a better rate. That means that most of the people getting insurance from this company are going to have fireplaces, which means they are going to have more houses catch fire, so they are going to have to charge higher premiums. Eventually they will be charging more than the $140 that their competition is charging because they will have fewer clients so they can’t spread the fixed costs out across their pool of clients as well. Then those with fireplaces will go elsewhere as well and the company will go out of business.

There is also another effect of this that is quite positive: people buying houses make better decisions. When they find out that if they buy a house with a fireplace then they have to pay more in insurance they decide whether it is worth the cost. Those that think it is worth it get a fireplace and pay the extra; those that don't think so don't get a fireplace. And everyone is happy. Now if this wasn't the case—if everyone was paying the same amount regardless of whether they have a fireplace—then those without fireplaces would be paying extra: they would be footing the extra insurance bill from everyone else having a fireplace without getting any of the benefits. If they knew this was the case they would start complaining.

Now most of you have probably assumed that the people that buy fire insurance in this example have houses that are not currently on fire. That's pretty reasonable, but let's think about what would happen if that's not the case. Suddenly things are a lot different. The insurance company then wants to start asking the important question "Is your house currently on fire?" when people apply for insurance. If so, the odds that the insurance company has to pay for fire damage is a little higher than if it's not on fire. So they do the same thing they did with fireplaces: they try and separate things out and calculate probabilities. They find out that if a house is currently on fire, then 60% of the time they are going to have to pay to rebuild it ($200,000) and 40% of the time they are going to have to simply repair it ($100,000). So then the insurance company says, "Your house is on fire right now? Sure we'll insure it. But we are going to charge you a premium of $160,000 to do so." That way they don't have to charge those whose house is not on fire a different amount.

Now if the prices of insurance for a house that is already on fire versus one that is not is not separated out then we see the same effect as we did before when we didn't separate out those with fireplaces (though it looks a little different). Suppose the insurance company just groups everyone together regardless of whether their house is on fire and they simply charge a uniform rate of $100 to each person. First of all, the insurance company will get an influx of people wanting to buy insurance when their house is on fire, so they have to raise their rates to compensate and stay in business. Even without raising their rates people will be inclined to simply wait until their house catches fire before they buy insurance. That way they can save money when their house isn’t on fire. But this means the insurance company has less people in the pool who are paying premiums and more people in the pool with houses that are burning down. They won't have enough money to cover the burning houses so they will have to raise their rates again to compensate. Then more whose houses aren't burning will stop paying insurance and the problem worsens until you only have people whose houses are burning left buying insurance. Thus, it’s pretty important that insurance companies are able to ask questions and segment the insurance pools. If they don't then large groups of people will not buy the insurance because the premiums are too costly.

Applying this to Health Insurance
Now let’s talk about what this has to do with health insurance. You are probably already making the connections. Health insurance works precisely the same way as the fire insurance example (taking into account, of course, the gross oversimplifications of the example).

Here is a list of a few of the prominent points being debated, most of which I took directly out of President Obama’s speech to congress a couple weeks ago. There are a lot of other points, some of which I would like to address—possibly in a future post. For now, let’s look at these specific ones:

• Make it illegal to deny coverage based on a preexisting condition
• Introduce a "community rating" system so that those that are sicker or have preexisting conditions couldn't be charged more for coverage
• Make it illegal to drop coverage when you get sick
• Remove per year or per lifetime caps on benefits
• Place limits on the amount of out-of-pocket expenses that can be charged
• Force insurance plans to include checkups at no additional charge
• Make it illegal to not have insurance

Now many of these could have very good results. What I want to do here is discuss some of the implications of these in terms of the insurance industry. Once we know what the change in the insurance industry will be from changing these things then we are more able to decide whether it is worth the extra benefit to make these changes.

First, let’s look at what happens when you make it illegal to deny coverage for a preexisting condition. This is very analogous to the fire insurance company having to insure people whose homes were already on fire. The insurance company is going to have to pay for those preexisting conditions, so they are going to have to take in more money from premiums to offset that higher expense. Insurance companies’ first inclination will be to do the same thing we saw in our fire insurance example: they will incorporate as much information about those it has to insure as possible into their probabilities and charge those with preexisting conditions higher rates.

This isn’t a very good outcome for those with preexisting conditions. This means that if you have cancer, the company is going to factor that piece of information in when calculating your premium and it’s not going to be cheap. To keep this from happening then, the insurance companies would be mandated to use a “community rating” system, so those with preexisting conditions couldn’t be charged more than those without. That’s like telling a fire insurance company it can’t charge a higher premium to those whose houses are already on fire. The money to pay for the houses that are already on fire has to come from someplace: it will come from higher premiums charged to the entire pool. Similarly, if those with preexisting conditions start having preexisting conditions covered, and insurance companies can’t legally segment the pools to include that information when charging premiums then they are going to have to start charging higher premiums to the whole pool. This means healthy people are going to be paying for those that have preexisting conditions through their higher premiums.

This same thing happens when talking about those that are sick that are already covered. The “community rating” system would mean that those that are already sick couldn’t be charged more than those that are not sick. This includes those that are older: older people tend to have more health expenses than those that are younger. If the insurance company can’t segment these groups apart then those that are sick, older, and/or have preexisting conditions will all be charged relatively the same amount as a younger, healthier person.

Insurance companies also cut costs by creating loopholes allowing them to drop your coverage or placing limits on the amounts that they pay in a year or over a lifetime. This is really bad for those affected; consequently, it is proposed that this be made illegal. This will make the costs seen by insurance companies go up—they have to pay for these new expenses that they were previously getting out of. Once again, they have to pay for this somehow: insurance premiums will have to go up to compensate. Since they can’t segment the insurance pools the premiums have to go up for everyone in the pool to pay for those that are very sick (those exceeding current limits).

Statistically, this could have a huge impact because of the magnitude of outliers. Suppose an insurance company is insuring 100,000 people and they expect to pay out $75 million dollars each year for those 100,000 people. That works out to be $750 per year per person in premiums. Now suppose that those numbers take into account a limit of $1 million in benefits per person and also suppose that limit is removed. Then there is one person in that 100,000 that needs to have a series of surgeries, transplants, medications, and therapy that totals $10 million—I don’t think this is unreasonable when dealing with healthcare. This makes the payout for the year $85 million which raises the premium to $850—all because of that cap was removed. That’s a big increase because of one person. As the pool size grows then the effect per person is less; but as the pool size grows, the odds that an outlier could cost significantly more than $10 million dollars also grows. The amount that an outlier will require cannot be easily calculated statistically and it doesn’t take very many serious outliers to cause devastating financial problems for an insurance company.

The only points I haven’t hit yet is placing limits on the amount of out-of-pocket expenses you can be charged for health care and forcing insurance companies to provide preventative checkups at no extra cost. From the discussion so far, I think it should be clear that this also increases costs seen by insurance companies (because now they’re paying for things they weren’t) so premiums will also be affected. True, those insured may then be able to get checkups at "no extra cost" but the costs will simply be built into the premiums which will be higher than they would otherwise be because of those extra "free" services.

Now if you are healthy and your premiums start going up because of all of the foregoing then you have more incentive to not get insurance. Why do you need it? The insurance companies have to cover your preexisting conditions when you finally decide to get it. So why pay premiums when you aren’t sick? Thus, healthy people drop out of the insurance pool, which causes medical costs per person to go up in the pool, which causes insurance companies to raise their rates further. Then more people have an incentive to drop out. Eventually, no one has insurance unless they are sick and insurance premiums become astronomical.

The solution to this new problem then is to require everyone to have insurance. Making it illegal to be uninsured would keep all the healthy people in the pool and allows insurance companies to function with non-astronomical rates while still covering preexisting conditions, the elderly, and the very sick. But then you have the situation that we talked about with the fireplaces in houses. If those with fireplaces are grouped with those that don’t have them then those that don’t have a fireplace are paying for the risk incurred by those that do have them. Same thing here: those that are healthy are paying for those that are not through higher premiums.

There would be a loophole to this, though (at least for some). People that don’t want insurance (and who don’t have an employer offering insurance) can pay an additional excise tax and not get insurance. If insurance rates are high enough this would be worthwhile: you could pay the cheaper tax until you get sick. If you do get sick, then you get insurance that legally has to cover your preexisting condition. Again, this would cause insurance rates on the pool to go up because healthier people are choosing to stay out of the pool until they get sick.

One positive thing to note, however, is that if that loophole is not very big so that overall more people have insurance than do currently, then it is possible (and probably likely) that this will bring premiums down from what they otherwise would be. This is because more healthy people would be brought into the pool to further distribute the costs incurred by the sicker people. Though I doubt this effect would be anywhere near significant enough to offset all of the other increases that I have discussed.

A Few Conclusions
When taken together then, these changes mean that a lot of people will be better off: those with preexisting conditions, the elderly, those that are sicker than average, and those that are really, really sick. All of these people are currently facing limitation on what benefits they get and are seeing higher premiums because of their current health. These are really serious problems that need to be addressed.

But these benefits also come at a cost: it means that those that are younger and not sick are worse off. Under this plan they would be subsidizing the health expenses of those that are sick, and the subsidies have the potential of being pretty large. Now that may not be entirely bad—in fact it might be worth it. But those who are deciding need to be aware of the costs that are being incurred because of the benefits that are being received.

Those that are pushing for these changes (like President Obama) are putting a lot of emphasis on the benefits to the elderly and the sick because of these changes. But there is not a lot of emphasis on the costs that are incurred in exchange for these benefits. Under this plan health insurance premiums would go up for the majority of people—particularly those that are the healthiest. This would make wages and income for those people fall significantly.

What we are talking about here is a method of income redistribution. Income will be redistributed from those that are younger and healthier to those that are older and sicker. The redistribution is simply hidden in insurance premiums so that most people are not aware that is what is being proposed. And President Obama and Congress are certainly not trying to let people know that is the case.

I think it is worth quoting here from the article I mentioned when I started:

[Because of these proposed policies] younger, healthier, lower-income earners would be forced to subsidize older, sicker, higher-income earners. And because these subsidies are buried within health-insurance premiums, the massive income redistribution is hidden from public view and not debated.

If Congress goes down this road, health insurance premiums will increase dramatically for the overwhelming majority of people. Even if Congress mandates that everyone have health insurance, many will choose to go without and pay the tax penalty. If you think people are dissatisfied with health care now, wait until they understand that Congress voted to mandate hidden premium increases and lower wages.

If you read this whole thing, hopefully you find it helpful to understanding (at least part of) the economic implications of the debate currently going on. Please comment—I’d like to hear what you think about this topic and also what I have said. Hopefully I’ll tackle another topic again soon.

Now that I finished writing this, I can’t help but wonder: Why am I working as a lowly support engineer at a software company?

Suspicious Semantics

President Obama was interviewed by 5 different networks over the weekend. Here is one short segment of one interview that I found interesting. It's a short conversation between George Stephanopoulos and President Obama about new taxation that is in the current health care reform bill. You can also read the text of the conversation from The Wall Street Journal or Fox News.

So President Obama is talking about imposing a tax on those that don't have insurance in order to create an incentive for them to get it. Regardless of whether this is a good idea, the fact is that President Obama apparently doesn't believe that such a tax is actually a tax. Now I'm pretty sure that this is considered a tax just about no matter who you are talking to. In fact, the text of the Baucus Bill itself (page 29) calls this a tax:

Excise Tax. The consequence for not maintaining insurance would be an excise tax. If a taxpayer’s MAGI is between 100-300 percent of FPL, the excise tax for failing to obtain coverage for an individual in a taxpayer unit (either as a taxpayer or an individual claimed as a dependent) is $750 per year. However, the minimum penalty for the taxpayer unit is $1,500. If a taxpayer’s MAGI is above 300 percent of FPL the penalty for failing to obtain coverage for an individual in a taxpayer unit (either as a taxpayer or as an individual claimed as a dependent) is $950 year. However, the maximum penalty amount a family above 300 percent of FPL would pay is $3,800.

But President Obama says it's not a tax. And he was pretty insistent about it. As I recall, President Obama has promised not to raise taxes quite a few times, including during his campaign and specifically in regard to health care reform. Here's what he told congress last week:

First, I will not sign a plan that adds one dime to our deficits – either now or in the future. Period.
...
The plan will not add to our deficit. The middle-class will realize greater security, not higher taxes.

And here is what he said to congress back in February about how his administration was going "to go line by line through the federal budget" to cut "wasteful and ineffective programs:"

If your family earns less than $250,000 a year, you will not see your taxes increased a single dime. I repeat: not one single dime.

But since this "isn't a tax," he can still sign the bill and keep all his promises (at least in his opinion) to not raise taxes by a cent—excuse me, by "one single dime"—in doing so.

So then, what does he really mean then when he says he's not going to allow an increase in taxes? Does he really mean that taxes won't be increased? Or is he going to have to continue redefining a "tax" in order to keep that promise?

Personally, I think this calls into question the validity of promises President Obama's makes. Apparently he can simply redefine commonly held concepts and definitions at his convenience in order to keep those promises. This also makes me wonder: is it often the case that what President Obama thinks he is promising and what most of the people hearing his speeches think he is promising are not, in fact, the same thing? That seems to be the case here.

A Shift in Political Perspective

The last couple of weeks I haven't spent as much time following the health care debate as I would like. I did listen to President Obama's speach tonight and then I spent some time doing some research about what I've missed in the last few weeks. There was one particular paragraph on Keith Hennessey's blog that struck me, although it is only tangentially related to the current debate:

I wish millions of Americans read KeithHennessey.com and were patient enough to learn the details to be as well-informed as you, my brilliant and thoughtful readers. But I believe imperfectly-informed involvement is better than complete disengagement. And I have a core confidence that, given time, the American people are on the whole smart enough to figure out the underlying truths and make sound judgments. I am a strong believer in the inherent wisdom of the common man. I am actually pleasantly surprised how relatively well-informed this debate is, compared to so many other policy debates I have seen. I will continue to do my part to contribute to a thoughtful, impassioned, civil debate.

Now this struck me because it blatantly flies in the face of the perspective I have had for most of my life. Historically, I have not been very up on politics. In fact, I have been completely disengaged. I didn't follow major issues and often felt kind of a dislike for people who did because they always seemed to think they knew a lot and never seemed aware of the things they were ignorant of or the complexity of the topics they held such adamant views about. I justified my inactivity based on the perspective that strong political opinion should only be held and voiced by those that had significant understanding of all the topics involved. I was no expert so I didn't feel qualified in expressing (or even forming) any opinion nor did I think that most people could credibly offer an opinion on most subjects.

About a year and a half ago a friend of mine chewed me out for holding that view. Among other things, he cited the fact that I often seemed to hold the opinion that people didn't understand the complexity of the issues they were discussing and that I seemed to indicate that I understood things better than average by pointing out that complexity. Yet I would never get really involved in discussions and would rarely go beyond implying that I understood a topic. It was his opinion that in reality those that didn't understand things all that well but cared and were at least active in political thought and discussion were doing far more good than I was. Furthermore, with my background in economics, he argued, I ought to be able to understand and do more than the average person, yet I did nothing and didn't seem to care.

I thought about that conversation a fair amount and ultimately decided I ought to take time to be more informed and involved. Since then I have gotten more and more into politics and economic issues. I've try to keep up with the news, particularly economic stuff. And I actually really enjoy it quite a bit. Now I am much more opinionated about a lot of issues and will discuss politics much more readily. (I even almost called in to a radio station the other day when they were taking calls.) I haven't blogged much about it, but I really would like to do that more.

So when I read the above paragraph tonight, I realized that my perspective on politics has shifted rather dramatically in the last year: I now actively reject the perspective I have described and that I have held. I think it really is quite important for people to be actively involved in political debate and discussion, even when imperfectly informed (which is the state that we all perpetually find ourselves in).

In light of my new found perspective, if you are currently disengaged from political discussion and involvement like I was, I encourage doing a bit of reading and at least forming opinions on things. Start with whatever topic interests you. For me it started with the economic policy; for others it may be military stuff, health care, the deficit, or any one of hundreds of other topics. I have found it really worthwhile.

Global Warming

If you haven't seen this video, The Great Global Warming Swindle, you should watch it. It was put out by WAG TV as a response to Al Gore's movie An Inconvenient Truth. It's a little lengthy, but worth the time. Not only does it give convincing scientific data that global warming is a natural phenomenon not caused by man, but it also gives a very motivating explanation as to why there is such hype around it and why that hype can be a very dangerous thing.

I've done a fair amount of reading on the topic and I personally agree with the views in this video: I believe in global warming but I do not believe that it is man made. Comments both for and against are certainly welcome.

The Case for Doing Nothing

Concerning the economy, I agree with this article quite closely. I think it is worth reading.

The Case for Doing Nothing
by Dr Jeffrey A. Miron

Legalization of Illicit Drugs

I know that I have mentioned to several people in various conversations the economic perspective that illegal drugs should be legalized. Unfortunately, I have not been versed enough in the details of the subject to give a very motivating argument. Dr Jeffrey Miron, an economist at Harvard University, published an article about the topic last week. It talks about the problems that illegal drugs cause and specifically the problems they have recently caused in Mexico. Here is the article:

Commentary: Legalize drugs to stop violence
by Dr Jeffrey A. Miron


Personally, I have not thought about the issue enough to have a strong opinion either way. However, I do think the arguments for legalization are substantative enough to at least be seriously considered. This is particularly true in light of articles like this one published yesterday in the New York Times about the current problems in Mexico.

I found out about the article from Greg Mankiw's blog, which I enjoy reading. Greg Mankiw is also a professor at Harvard.