30 December 2005

The Nature of Insurance

For some folks, this post will be a big “well, duh!” sort of thing but based on a conversation I had a while back, it seems that there are lots of other, plainly intelligent people who really need to hear this.

Imagine a woman who is thinking about leaving her job to pursue other things. But she’s someone who takes a prescription medication and is concerned about loosing the health benefits her work provides – she doesn’t think she can afford the pills on her own. For the record the pills would be about $100/mo and they are not “life-saving” but rather “comfort-enhancing.”

“It’s not fair!” she says, “Somebody ought to pick up the cost of those pills. I need them!”

After brainstorming on how she might come up with an additional $100/mo I realize that she really isn’t talking about insurance at all. What she’s looking for is a subsidy. What she really wants is for somebody, either the government or her employer, to pay for her medication regardless of the need, regardless of the cost, and regardless of whether she is paying her fair share of the cost either with cash or labor.

This is a particularly important distinction to make as our nation repeatedly argues over health insurance and how much of it should be picked up by the government. Regardless of the details of that debate, it seems to me that we need to be careful about the terms we’re using, and what I generally hear from the left isn’t really about insurance – it’s about a subsidy.

Insurance is supposed to work in this way:
  • Statistically (for example) 1 in every 10 adults will break a bone this year.
  • Fixing a broken bone will cost $100
  • Since nobody wants to pay $100, instead, 10 of us get together with an insurance company and each pitch in $11 a year.
  • Then when one of us breaks a bone – and statistically somebody will - the insurance company pays the $100 doctor bill and keeps the $10 left over.
  • Folks for whom $100 isn’t really a big deal might choose to keep their $11
  • Folks who figure they are significantly less likely than 1 in 10 to break bone might keep their money figuring they’ll just save $11 a year toward that broken bone and can pay for it themselves in just over 9 years.

So the point is to spread the financial risk out across a bunch of people so nobody gets hit with a huge bill when they are the unlucky one. Instead, they pay a small bill regularly toward the possibility (inevitability?) that something bad will happen to them.

Here’s where insurance starts to break down:
  • In an effort to attract more customers, insurance companies agree to cover more and more eventualities. The broken bone policy becomes a general “health care” policy.
  • Doctors, who know that virtually none of their patients actually pay the doctor bill themselves, have no motivation to moderate prices.
  • Patients, who never pay more than their $11 a year don’t know or care what any given procedure costs so they don’t shop. Similarly, they use their insurance policy to get things it was never intended to. Got a stuffy nose? Instead of the $8 Dayquil at Rite-Aid, they go get a prescription for Clarinex - $50.

In short, insurance only works when there are no more than the same numbers of dollars going into the pot as are being withdrawn. It only takes two people in the example above to break the system in any given year. Two broken bones means the insurance company lost money. They took in $110 and paid out $200.

It’s also important to look at on a purely individual basis. If I pay my $11 on my first year, then break my arm and back out of the deal – I’m screwing everyone in the plan. I paid in $11 and got out $100  - only to take my business elsewhere. You see this kind of thing all the time with folks who are uninsured but then find out they are pregnant. Suddenly The Baby family buys into a $100/mo policy against their $5000 baby in eight months and cancel the policy three months after the baby is born. It’s legal, but it’s exactly the kind of thing that drives insurance rates way, way up. This family has paid about $1000 for a $5000 procedure – you know who paid for the other $4000? You, me, and eventually that same family when they get their acts together. Because when Mr. Baby gets a good job, his company will pick up his insurance premium which is artificially high due to scads of folks like Mr. Baby, and his employer will directly deduct the cost of his health premium from the wage they offer him. In other words – Mr. and Mrs. Baby actually screw themselves – ironic isn’t it?

But that’s the subsidy mentality. At some level, conscious or unconscious, Mr. and Mrs. Baby believe that the money to pay for their baby is “out there” just waiting to be collected. They are willing to eat at this potluck, but not to contribute their fair share. But there is no money “out there” - tax money simply comes from your pocket and mine – we all eventually pay the piper.

So back to this woman who was leaving her job. Over time, she had stopped even noticing the deduction on her pay stub that covered her health benefits. She no longer was even aware that about $220 was taken every month – more than twice the cost of her medicine. Also, it was only when she started thinking about quitting that she asked what her pills cost, before it was a non-issue. And she had never even considered the generic brand pills that were $25/mo – because for her, the money was just ‘out there’ and she had come to think that she was entitled to it. Depending on who gets their way on this issue, she may be in time. But we have to call things what they are – this woman wanted somebody else to pay for her medicine, which is a subsidy. She had forgotten what insurance even was if in fact she ever knew.


Devin said...

I know that I have been guilty of this kind of thinking. I have been fortunate enough to have parents who have been willing to bail me out financially when I've really needed it. A sizable reason of why I can go to art school is because money has been provided to me by outside sources (though, of course, my wife and I are expected to pay off much of it). It's been difficult to shake the mindset of "the money is out there."

I heard something interesting on television tonight. The PBS station out here was showing a documentary about 19th century Minnesota, based entirely on the letters and diary entries of residents. One set of entries spoke about a period of four years in which locusts ravaged the prairies and farmlands of Minnesota (which you can read about in 'Little House' books by Laura Ingalls Wilder). Food stores were perilously low, and people were getting very worried about survival. The governor [or the mayor, I can't recall] decided that it would "harm the moral fiber of the people to distribute handouts", and instead declared a holiday for Minnesotans to devote themselves to a day of fasting and prayer.

And it worked. The locusts didn't come back that year. Say what you will, but that's what history records.

Anonymous said...
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Silverback said...

Check it out! My first SPAM comment! I have totally 'arrived' now that the spammers see me as a valid target. :)
In the future, I'll be sure to delete crap like this, but this one will instead get framed like my first dollar bill!

Anonymous said...

hi, i am making a dissertation on insurance..thoygh your article was not of much use to me but i must say it was excellent.i have read so many aricles for making my project but, believe me....this was the best one

James Morgan - Puritan Financial Advisor said...

This is a particularly important distinction to make as our nation repeatedly argues over health insurance and how much of it should be picked up by the government. Regardless of the details of that debate, it seems to me that we need to be careful about the terms we’re using, and what I generally hear from the left isn’t really about insurance – it’s about a subsidy.