Written by Thomas Cox   

Most Americans, whether insured for illness and accident or not, simply do not understand what has really happened over the last 40 years. This failure to understand how insurance works and the consequences of this ignorance are severe. Americans continue to think they have benefit plans that will be there when needed and only find out, far too late, that these benefit plans are worthless.

Insurance professionals, chiefly actuaries, play two roles that few understand. Certainly they play important and disclosed roles in maintaining the adequacy of insurance company reserves and keeping insurance companies from charging less for their services than will be sufficient to guarantee long term solvency. This is the high road for actuaries.

But actuaries also play a less noble, obfuscatory role by making the mechanisms through which insurance reserves and premiums are calculated, promoting the image that like some sort of Witch Doctor or Shaman, they have some secret knowledge that lesser mortals do not possess that allow them to see more clearly and more distantly the things that mere mortals cannot see at all. Through complicated mathematical and statistical formulae they promote the idea that mere mortals cannot possibly hope to understand the manner in which insurers earn their profits and avoid losses.

This is nonsense as will be revealed below. Far from being difficult to understand, insurance rate making and reserving are quite easy. If an insurance company that writes 1,000,000 identical policies is stable, has adequate reserves, and has a high probability of making at least 5% profits for its stockholders, an insurer writing 100,000,000 identical policies will be more stable, will have more adequate reserves, and be more profitable. As a corollary, an insurer writing only 10,000 identical policies will be less stable, will have less adequate reserves, and be less profitable.

A single, large, and responsible insurer, writing 307,000,000 identical policies can deliver more benefits, be more certain of achieving its modest profit and solvency goals, and do this at lower cost than any collection of smaller insurers. This isn't political dogma, it is a consequence of the law of Large Numbers and the Central Limit Theorem.

Large insurers are more efficient risk managers than smaller insurers in the same sense that polling data that is based on larger samples tends to better estimate the true intentions of voters than polling data based on small samples. The real objective of insurance companies, despite how the entire industry has been corrupted by greed, is to generate loss ratios close to the average for the population of policyholders. Any insurance company can generate profits by withholding benefits and delivering lower benefits than their competitors, but that is a monumental perversion of the concept of insurance. Despite its embrace by the managed care sector, this perversion has ravaged the insurance sector and the health care sector.

Insurance works by aggregating risk, combining the exposure to extremes of loss of many in one place, and when this is done the future experiences of the insurer tend to become very predictable, falling at or near the average, or expected loss for each policyholder. It is this greater predictability that is the hallmark of successful insurance operations, not dramatically lower loss ratios. Each policyholder pays an amount slightly larger than their expected loss and the insurance company does its magic by combining all these risk exposures in one place at a price far lower than would be need to be set aside by each policyholder to adequately fund a reserve for illness or injury adequate to assure their ability to pay for all the care they would need in the event that they become ill or injured.

While each of us could sustain losses of hundreds of thousands of dollars for a serious, sustained illness or injury, few of us will actually sustain such illness or injury. Instead, we will incur costs far below the average. A few of us will sustain costs of $50,000; $100,000; $250,000 or more. Despite the fact that few of us will sustain such costs, if we did not have insurance and wanted to be sure that we would be able to afford such care we would actually have to set aside that much money. 307,000,000 Americans setting aside a quarter of a million dollars apiece, even if it could be done, would cost 77 trillion dollars - a poor way to invest such wealth. Instead, through a dynamic and healthy insurance mechanism we could each be guaranteed a reserve of $250,000 if needed, at a far more modest cost of $2,000 - $3,000, per person, per year.

This is simple. There is no wizardry involved, no magic potions, incantations, or esoteric knowledge. All that is required is a simple grasp of basic statistics, economics, and finance. Despite this we are repeatedly told that the solution to the health care finance dilemma is ore competition between insurers = more smaller, inefficient insurers. This is nonsense.

Let's look at this a little more carefully. We describe a paradigm insurer (PI) allocating premiums as follows: Expected loss ratio $0.75, Profit contingency $0.05, Risk premium $0.05, and Non-loss related operating expenses $0.15. PI writes 1,000,000 policies at random, and the standard error of PI's estimate (i.e. PI's actual loss ratio) of the population loss ratio is $0.05. Using some very basic statistical and financial ideas, chiefly the normal distribution and the financial implications of risk management through insurance, we can elaborate on the experiences of PI and smaller and larger insurers.

PI earns profits of at least 5% at or below loss ratios of $0.80 with probability 0.8413. PI avoids operating losses (LR ≥ $0.85) with probability 0.9772. Insolvent (bankrupt) insurers cannot honor commitments to employees, stockholders, policyholders, or health care providers. We require all insurers to set aside liquid assets, called "Surplus," sufficient to prevent insolvency with probability 0.9987. PI's surplus requirement is 5% (0.90 - 0.85) of its gross premium revenues, protecting it from a loss ratio at or below $0.90.

We will show that insurers smaller than PI have lower probabilities of: earning profits of at least 5%, avoiding net operating losses, and avoiding insolvency than PI. Insurers larger than PI have higher probabilities of: earning profits of at least 5%, avoiding net operating losses, and avoiding insolvency than PI.

Portfolio size and profit objectives determine the maximum sustainable benefits (MSB) insurers provide. PI can aim at its MSB ($0.75) throughout the year and meet the performance standards above, while smaller insurers have lower MSBs and larger insurers have higher MSBs if they both seek profits of at least 5% with probability 0.8413.

The essence of insurance is managing the variability around the average loss for the population. As is true when performing statistical sampling, the more policies written the closer to the average for the population an individual insurer's loss ratio will be. A much smaller insurer has a greater probability of a loss ratio far from average. A much larger insurer has a very small probability of a loss ratio far from average. Since the large insurer is unlikely to face a large loss ratio it can deliver more benefits, charge less for its risk management services, and still achieve its profit goals because the larger it is the less likely it is that it will suffer a catastrophic loss ratio.

There are two ways in which the current rhetoric is flawed. First, as suggested above, more competition between insurers is simply more inefficient insurer sizes - a useless ploy. The far more critical flaw is the insurance and managed care industry practices of putting health care providers (Physicians, hospitals, nurses, long term care facilities, and home health agencies, in the insurance business. Capitation, a principal component of this effort exists in managed care programs, insurance operations, and even the Medicare and Medicaid programs. Insurance risk assuming health care providers are paid average amounts - the classic notion of an insurance premium - and for this average payment they are expected to provide the unknown costs of care.

This practice, which I call "Professional Caregiver Insurance Risk," will continue, perhaps grow even more common, under the major outcomes of the current health care finance reform debate. There are approximately 1,300 "health insurers" currently operating in the United States, an incredibly inefficient number. But the real insurers are no longer insurance company bureaucrats but doctors, nurses, hospitals, nursing homes, and home health agencies. These millions of insurers are all so small and inefficient that they cannot deliver anywhere near the benefits that can be provided by well run, well regulated insurers.

Insurance risk assuming health care providers must deliver dramatically lower benefits than available through legitimate insurers and this is the real flaw in the modern health care finance system. But this system generates huge profits for risk transferring managed care plans and risk transferring insurers, and dramatic cost reductions for the risk transferring Medicare and Medicaid programs. These risk transfer create millions of tiny, undisclosed, and inefficient insurance decisions every day as patients are treated for less costly problems while costly, potentially life threatening, problems are ignored. Your friendly physician is more than happy to issue a prescription for antibiotics for an ear ache because you will leave happy and minimal time and cost is involved. Treating you for breast cancer, on the other hand, is far more time consuming and costly, so such decisions are much more difficult to make.

Despite the obvious nature of the greatest threat to our health care (finance) systems, the roles played by health care providers, qua insurers, is completely ignored in the current debate. There is no intent to address this evil despite the fact that millions of Americans are being harmed each day.