The Economics of Health Insurance Companies – Serious Stuff

And Why Insurance Companies are So Unpopular

In economic policy it turns out that a lot of folks who know little or nothing about economics, and even some that do, see the Gang of 150, operate on faith rather than logic, data, analysis and models.  A great example of this is the Ryan proposal on health care for senior.  It is taken as a given that competition among private insurance companies will result in lower health care costs, even though not only is there no data to support that, but also that the experience of the last 30 years is that health care costs in the non-senior sector, which is primarily served by private insurance companies, has risen  in an almost out-of-control manner.

From a political point of view, The Dismal Political Economists wonders why Mr. Ryan has chosen to turn over health care for senior to private insurance companies, when those companies are almost universally disliked by their policy holders.  Health insurance companies are blamed for denying coverage, for raising rates excessively, for not caring about policy holders, for being bureaucratic and difficult to work with and in the extreme for denying dying people the treatment needed to keep them alive.  To the amazement of The Dismal Political Economist Mr. Ryan wants to take the most successful and highly thought of government program in existence and turn it over the a group of companies people largely despise, and even more amazing is the fact that Mr. Ryan and his Republican colleagues are surprised that this is not very popular.

To understand the problem with putting private health insurance companies in charge of health care for Seniors one has to understand the economics of the health care system and the role of private health insurance.  The U. S. health industry is largely pay-for-service.  Health care providers get paid when they provide health care services, and do not get paid when the do not provide health care services.  In the parlance of basic Financial Management 101, this makes them variable costs to the patients. 

So the more health care services a patient needs, the higher the cost.  This is a risk that most patients and potential patients would like not to have.  Insurance is the means by which risk is shifted from one group to another, for a price, which is called the premium.  The premium is a fixed amount, so that insured’s risk is limited to the premium (and small co-pays and deductibles if they are present).  The risk of a huge medical bill now resides with the Health Insurance Company, and it has a fixed revenue amount covering a variable obligation.  Basic Financial Management 101 says this will not work.

Unlike other types of insurance, for health insurance this is an untenable situation.  In life insurance, the risk is untimely death of the insured.  However, the payout amount is known and fixed, and actuarial science can pinpoint and quantify the risk to an almost 100% amount.  Casualty insurance, primarily structure and auto, also has a limited risk for the insurance company, namely the maximum amount of the policy and the probabilities are also well known.  Life insurance and casualty insurance are relatively risk free for an insurance company, and hence very profitable.

A company that provides health insurance has a different and much more complex risk structure.  The claims on the insurance company are variable, the more health care provided the more the insurance company has to pay out.  Furthermore the insurance company has little control over the health car costs it pays for.  They are determined by the health care providers, remember, those who make more money the more care they provide. 

So a Health Insurance Company is caught in the middle.  It collects fixed premiums from the insured, and pays out on a variable basis to health care providers.  This brings up a huge clash, with health care providers wanting to get more money, and the health insurance company wanting to pay less and the insured who wants all the health care in the world regardless of the cost.  The insured does not care, they pay the premiums and that take care of their end.

The health insurance company must be the one to police the system, saying no to cost ineffective treatments and unnecessary costs to both insured and provider.  But it is ill equipped to perform this role.  Each individual insured is unique and it is impossible for the insurance company to say whether or not treatment is needed and how much it is worth.  Like any regulator who has the job to say no, it is not very popular with either of the two parties, the insured and the health care providers ,to whom it is saying no.

This is just one of the reasons why the Ryan plan will not work.  It places private insurance companies in the role of regulator of health care costs, and history, logic and our current experience with private insurance for the non-senior market has shown that private health insurance companies do not hold down costs.

  A better way must be found.  We know what to do, we just have to do it.