First Principles of Health Insurance

23 December 2009 |

As noted in my previous post, health insurance reform is all but certain to pass the Senate this week. Since the House has already passed a bill, the most sweeping changes in history are about to hit the health care insurance industry—changes that will affect every person in the United States. I cannot think of another law that affected literally everyone: payroll taxes affect only the working; Medicare affects those over 65 years old; wars affect mainly those in the military and their families. Health insurance reform touches everyone—from the cradle to the grave.

Since we do not know the final provisions of the law, and will not know them until the Senate bill is reconciled with the house bill, there is nothing to do but to take a deep breath and wait. That is, unless you do not have health insurance at this time. In that case, you should get some kind of health insurance immediately (see previous post for reasons why). 

The lull before the passage of health insurance reform legislation is the prefect time to consider the first principles of health insurance—and all insurance. It is impossible to accurately analyze health insurance reform legislation without an understanding of these principles.

The foundation of all insurance is shared risk: Each person pays a small amount, known as a premium, toward a policy with an insurance company; in exchange, an insurance company agrees to pay for losses covered by the policy. Catastrophes—to property and even to health—do not occur continuously to everyone. Rather, they are relatively rare. Insurance spreads the cost of those catastrophes among a large group of people. The participants in the policy share the risk. When catastrophe strikes, the insured is covered. The funds to pay for the losses come from the premiums paid by all policyholders.

The public first became aware of the concept of shared risk in the aftermath of the Great Fire of London in 1666, which destroyed more than 13,000 homes. Physician and businessman Nicholas Barbon introduced the idea of a large number of homeowners paying a small amount to ensure that their homes would be rebuilt if they burned in another fire. Maritime magnates had been insuring their ships against loss for some time, but insurance against loss had remained a concept reserved for large enterprises. Bardon brought the concept to the masses when he pioneered the first fire insurance for homeowners.

The idea of shared risk grew in popularity and was transplanted to North American, first in Charleston, then in Philadelphia, where, in 1752, an enterprising young man named Benjamin Franklin founded the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. Instead of charging insurance premiums spread out over time, Franklin’s organization took a single deposit from the policyholder. The company agreed to pay for losses due to fire at any time during the life of the policy. When the policyholder cancelled the coverage, Franklin’s organization returned the deposit. The company prospered by investing the money during the term of the policy.

Shared risk works only when the premium amount is calculated carefully. If the insurance provider charges too little in premiums, it will not have the resources to pay claims. If it charges too much, it cannot compete with other insurance providers.

The cost of the premium is based on the risk that a loss will occur and the cost of the loss if it does. These calculations are based on a statistical modeling known as actuarial science. Actuarial scientists, or actuaries, constantly refine their models being made to more accurately forecast losses and more fairly calculate premiums.

Health insurance adheres to these same principles and methodologies. Each person’s risk of requiring medical attention is calculated based on age, weight, sex, and other factors. Because actuarial science accounts for individual differences, shared risk is inherently fair: The young and healthy pay less than the old and sick do.  Nonsmokers pay less than smokers.

The health insurance reform measures being considered by Congress turns actuarial science on its head. Both the House and Senate versions of health insurance reform require that older Americans cannot be charged more than three times as much as younger Americans, even though they are five or six times as likely to have serious illnesses. Closing the actuarial gap via mandate means that younger people will be paying much more than their risks suggest they should—and much more than the present system requires them to pay.

The same goes for insuring those with preexisting conditions. By forbidding the insurance companies from delaying or denying coverage to those who are seriously—even terminally—ill, the government is requiring the insurance companies to accept enormous risk with no way of sharing it adequately among policyholders.

Such a system violates the principles of insurance. As a result, it is not sustainable—without massive infusions of taxpayer money. When actuarial science is replaced by political expediency, you no longer have insurance. You have a government entitlement masquerading as insurance.

That is what Congress is giving us.

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Health Insurance Uncertainty

18 December 2009 |

At this writing, the future of health insurance in America remains uncertain—but all that could change by Christmas Eve. That is when the Senate is scheduled to vote on its version of the health care insurance reform plan that has been under debate for months now. Many people are asking me what they should do about health insurance right now. Here are a few practical steps:

1. If you do not have health care insurance, get some. It is not clear if the Senate will pass health insurance reform, but even if it does, the Senate bill will have to be reconciled with the House version. That could take some time. In the mean time you need to protect your assets from the high cost of unforeseen medical expenses.

2. Even if health care insurance reform passes, any benefits—e.g. outlays from the government—will not be available until 2014. The requirement to get private health insurance may take effect before then, and your private health benefits will be available immediately, but waiting for the entire program to be in place before you make a decision is not wise. I recommend getting standard private insurance in the mean time, just in case you have a serious illness or injury.

3. The new law will likely supersede the Health Insurance Portability and Accountability Act of 1996 that provides a 63-day window to purchase insurance without losing “continuous coverage.” It is not clear, however, when this provision will take effect. If you lost your healthcare insurance due to job loss, relocation, divorce, or any of a number of reasons within the last 63 days, you must act quickly to preserve your “continuous coverage.” Under HIPPA, the time you participated in a previous health insurance plan counts toward offsetting any waiting periods for preexisting conditions. For example, if you had health insurance for three years then had your health insurance coverage terminated, the three years of coverage will offset an exclusion period of, say, 18 months. Unfortunately, if you delay buying insurance until the 63-day window closes, then you might have to wait 18 months before your insurance policy covers your preexisting condition.

4. It seems apparent that any new legislation will require every working adult to buy some kind of health insurance. Even if the “public option” is not part of the bill, mandatory coverage through private insurance companies will be. It goes without saying that insurance companies will be deluged with new customers. This will cause a processing nightmare, resulting in unprecedented delays. By enrolling now, you can avoid getting stuck in the bottleneck, and it will be relatively easy to modify or switch to new options as they become available.

The astronomical costs of a serious illness or injury can wipe out your savings and non-liquid assets, such as home equity. That is a gamble no reasonable person should take. There will be plenty of time to take advantage of government-mandated health insurance—if there are advantages to be had—if and when such programs take effect. For now, I strongly advise getting some form of private insurance.

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