The Nonsensical Private Insurance Model

Today, I’m going to try to convince you that private insurance companies should not exist. Okay, maybe that’s a bit hyperbolic, but let me explain. The basic premise of insurance is that, by pooling people together, risk can be made more manageable. Say, for instance, that historical data indicate that 1 in 10,000 people will develop a rare illness that is very expensive to treat. In fact, let’s say that the cost of treating that illness is a cool $1 million. Because most people aren’t millionaires–our group of 10,000 people might contain none at all–being the individual with the illness goes from being a health concern to being a financial concern as well. Bankruptcy is almost assuredly the outcome.

But there’s some uncertainty in the risk. None of the 10,000 people knows if they will be the one to contract the million dollar illness. At this point, they have two options: They can take their chances–after all, there’s only a 0.01% chance that they’ll get the illness–and figure out how to come up with the $1 million if they become ill, or they can pool their risk with the other 9,999 people and buy a product called health insurance. In our simple little single illness world, where probabilities always work out nicely, we might imagine a scenario where the total health care expense would be $1 million (the cost of treating the illness for the one person who contracts it). The fair thing to do, then, would be to charge everyone a premium of $100. That’s the break even point, anyway. And it’s obvious why the one person who falls ill would want to have this insurance–$100 is a lot cheaper than $1 million. In fact, because people are typically risk averse, they’d rather go ahead and pay the $100 with certainty, rather than letting a million dollar bet ride on an open ended “what if?”. Risk pooling works in theory.

Of course, the world is not so simple as our little experiment happens to be. Instead, the total health care expenditures would be far more than $1 million for the group, because people would contract other illnesses, develop other diseases, and even spend money for routine check-ups. But we have data on that amount of utilization, too, and the setup is the same. Figure out how much our population of 10,000 people is expected to cost, divide that total by 10,000 and charge everyone that same amount. Welcome to community rating.

But people don’t like that approach. After all, some people in our group of 10,000 smoke and some do not. Those who don’t smoke aren’t often excited about paying a higher premium to cover the cost of lung cancer treatment that has its origins in the bad decisions made by smokers. It’s kind of like going out to dinner with a big group that eats and drinks its fill while you have a salad and a glass of water. At the end of the night, they want to split the check evenly, and you don’t want to subsidize their wine habit. Surely there must be some system that figures out your own personal risk category and charges you accordingly. Welcome to experience rating. Obviously, this leads to stratification that is antithetical to the solidarity inherent in the concept of risk pooling, but that’s a subject for another post.

Figuring out everyone’s risk, and the costs involved requires actuaries. Sending out the bills for the premiums requires administrative staff. In other words, running the risk pool takes work and is associated with additional costs. These, too, must be added to the total health care expenses in determining the break even point for premiums. And, if the government ran health insurance, it could stop there. The calculation would simply be:

Per enrollee premium = (total health care costs + total administrative costs) / number of enrollees

When private companies get involved in the insurance business, things get more complicated, because one of the goals–even if the company is technically a non-profit–is to make money. There’s only one way for that to happen, which can be explained by the following formula:

Per enrollee premium > (total health care costs + total administrative costs) / number of enrollees

It looks almost identical to the government equation, with one difference: the equal sign has been replaced with a greater than sign. There are two primary ways that this can happen. The insurance company can charge a higher premium, or it can deny claims–essentially asserting that “total health care costs” are lower than the enrollees would claim. If they do both–increase premiums and deny claims–they stand to make even more money. Now, conventional wisdom would suggest that if the insurance companies did this, people would leave in droves. Unfortunately, imperfections in the market make this easier said than done. For starters, as I discussed last week, most people have no idea how much their health insurance premiums actually cost.

The bottom line is this: Insurance companies profit the most when you pay them and they don’t pay your claims. They have a financial interest in denying you your benefits. That makes about as much sense as McDonald’s earning 10 cents on each hamburger it sells, and 20 cents on each hamburger it doesn’t sell. There’s an inherent conflict of interest in the private insurance business. The government, by contrast, isn’t in the business of making money. I think even my conservative friends who want to slash domestic spending and lower taxes would agree that. As a result, they are perfectly content to break even, and the only claims that they would have an interest in denying would be fraudulent ones. As I see it, this moves us away from the inefficient world of private insurance towards the purest risk pooling function that only government can provide. People freak out about this (a technical term), because they distrust government and can’t envision any scenario where the profit motive doesn’t generate the ideal results. Apparently, these people prefer the idea of paying more and getting less to the idea of getting what they pay for.

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