Principles and Economics of Health Insurance - Part 1

[Editor’s Note:  Discussions on Medicare, Medicaid and health care plans in general are dominating the political and economic news.  The impetus is (1) the runaway costs of medical care and (2) the lack of sustainability of the current Medicare and Medicaid models.  All of this revolves around health insurance, but a perusal of the discussions shows that a large majority of those talking either lack basic knowledge of health insurance as a risk management concept, or are so misinformed that their comments border on the ridiculous.

As a result The Dismal Political Economist has written a series of posts which will explain the basic economic principles behind risk management and insurance, in the hope that while he does not expect agreement on the various points of dispute, at least the parties may be able to come at the issue with a basic understanding of the dynamics of the issue.]

Insurance is a form of risk management.  In its purest form it enables those subject to the risk of an adverse event to shift that risk to another party, and the other party will be either better able to manage that risk, or in some cases able to eliminate a large portion of the risk altogether.  This risk shifting is not free, it involves a payment from the economic unit that has the initial risk exposure to the economic unit that assumes the risk exposure.

In order for insurance to be a viable option two conditions must take place.  A basic model of insurance contains these variables.

E = the adverse event that result in risk

P(E) = the probability that the event will take place

L = the expected loss if the event takes place.

PM = the payment that the unit subject to E makes to obtain insurance against an occurrence of E.

In order for insurance to work as a method of risk management, two conditions must be present with respect to these variables.

1. P(E) must be a very low number.

2. L must be a very high number.

The reasons for this are obvious, but bear repeating.  If P(E) is not very small, no gains can be made from risk shifting.  When E is very likely, the loss will simply be borne by another party, and that party would require payment nearly equal to the Loss, which eliminates any motivation for the economic unit subject to E to obtain insurance.  Similarly, if L is very small, then the benefits of insurance are very low and the economic unit subject to E will have little or no motivation to obtain insurance, no matter how low the cost.  The economic unit subject to the risk of E will simply absorb the lost itself.

Insurance is thought to have begun at the same time as trade between geographically separate areas began.  As caravans started to convey goods across wide distances, they incurred the risk that the goods would not reach their destination, due to weather, attack by unfriendly forces and other factors.  While the probability of such a loss was not great if the caravan was properly organized and protected, that probability was not zero and the loss, if it did occur, could be catastrophic to the owners of the goods which were in transit.

For these reasons, insurance became a natural part of the caravan trade, because it met the two conditions listed above.  The probability of a loss was low, but the amount of the loss, if incurred was very high.  Owners of goods that were being shipped across long distances had a very real incentive to purchase insurance.

Next:  How  insurance is provided.