What is Insurance?
"Insurance is, to begin with, and most obviously,
the crucial mechanism by which we spread risk. As such, it provides
economic security and greatly facilitates commerce and enterprise. It
reduces uncertainty, trepidation and fear; it lubricates the engine of
The Invisible Bankers
How it works
Insurance is about managing risk. By paying a predetermined amount
of money, a consumer limits exposure to unknown (and difficult to plan
for) amounts of money if certain conditions occur; a small, known cost
offsets the eventuality of an unpredictable, large loss.
There is no doubt that a serious illness or accident can result in
major losses. Most Americans literally cannot afford to get sick,
Californians, as in other parts of the country, are hard hit.
According to the Heath Care Financing Administration, the state's 1996
per capita spending for medical care was $3,391 - due in large part to
the high cost of doctor and hospital services. Except for the very
wealthy, few consumers can afford access to primary healthcare without
A Simple Example
Hospital care in Los Angeles today costs about $4,700 per day. For
example, a hypothetical thirty-year-old Los Angeles resident we'll
call Sherman, knows he cannot afford this expense on his own, so he
pays $150 each month for typical health insurance plan (he could have
paid considerably more or less, depending upon the type of plan and
the nature of coverage).
A few months after buying the coverage, Sherman becomes ill and is
hospitalized. After his first day in the hospital, charges exceed all
the premiums he would pay in over two-and-a-half years. After five
days, his bills would exceed his premiums for the next thirteen years.
Someone has to pay Sherman's bill, and few hospitals or doctors
will wait thirteen years for reimbursement. The bulk of the charges
will be reimbursed by Sherman's health plan. The source of this
payment will be, essentially, premiums paid by customers who have not
incurred significant claims.
Healthy customers contribute to the payment of claims incurred by
unhealthy consumers in exchange for the assurance that, if they incure
covered medical costs, the health plan will pay them.
Of course, not every dollar of premium goes toward paying claims.
Every insurance program, whether run by commercial enterprises,
non-profits or governmental agencies, incur administrative costs and
must set aside funds in reserves. Non-profits also plan on adding to
their surplus and commercial plans seek to earn a profit.
Costs must be paid
To understand how health coverage works, it is important to
recognize that costs must be paid. Sherman may have received a substantial
financial benefit (paying just $150 per month while gaining thousands
of dollars in benefits), but many customers participated to create
that bargain. Health plans have only three sources of income to use
for claims: 1) premiums, 2)money earned from investing those premiums,
and 3)reducing operating expenses. If these sources of income cannot
cover the benefits promised, the health plan must reduce benefits,
raise premiums, save money through increased efficiency, or some
combination of the three.
The significance of how benefits affect premium costs cannot be
overemphasized. For example, imagine a health plan that includes a
benefit of $1,000 (with no deductible, waiting periods, pre-existing
condition exclusions or other limitations) for those enrolling in a
weight-loss program. Also, imagine that this health plan is sold
through weight-loss clinics, which charge $1,200 for their programs.
Assume that 1,000 consumers purchase the health plan. It is extremely
likely that every one of those covered individuals will submit a claim
for the full benefit amount. How much should the plan charge for this
If each of these 1,000 consumers submit claims for $1,000 (a certainty
in this extreme case), the health plan must pay out a total of
$1,000,000, unless it can negotiate a discount from the weight-loss
clinics. In this example, there is no spreading of the risk. Indeed,
there is no risk to spread - there is only the certainty that
$1,000,000 will be paid out in claims. The amount charged to each
covered member for this benefit would have to be $1,000, plus an
amount to cover administration costs and an addition to reserves of
To summarize in broad terms, the two primary factors influencing the
cost of health coverage are: 1)the expected cost of medical services
in a given geographic area, taking into account negotiated discounts;
and 2)the likelihood that a covered individual will use those
services. The health plan's goals are to provide coverage at a fair
price, and to pay claims, costs, and earn a fair return or, in the
case of non-profits, an addition to surplus.
Medical care costs historically have increased at a rate substantially
faster than consumer prices in general, and insurance premiums have
risen to keep pace. For example, between 1980 and 1990, national
health expenditures increased by nearly 400 percent. Moreover, the
Health Care Financing Administration is projecting that national
health spending will double from 1997 through 2007, reaching $2,2
trillion in 2008 and comprising 16.2 percent of the nation's GDP. As a
result, healthcare spending increases are projected to average 1,8
percentage points above the GDP growth rate from 1998 through 2008.
Other factors contributing to the dramatic increase in health
insurance premiums include:
- increased cost of prescription drugs
- growth in spending for physicians and hospital services
- new medical technology, and
- an aging population
In addition, states have enacted a broad range of health insurance
mandates since the late 1980s, which have increased premiums. These
mandates force insurers, employers, and managed care companies to
cover - or at least offer - specific providers or procedures not
usually included in a health plan. A recent Milliman and Robertson
study of the 12 most common state mandates (for example: mental health
care, chiropractic and infertility treatments) found that such
mandates can increase health insurance premiums by as much as 30
Insurance companies cannot predict how much in claims any particular
individual will submit for a particular ailment. However,
they can analyze information about large numbers of consumers to
predict how many in a population can be expected to submit claims, as
well as the nature and cost of those claims. Using those predictions,
and adjusting for the cost of the factors listed above, plus overhead,
profits, and addition to surplus, health plans develop a premium for
Since the goal of health plan is to spread the risk of advertising
financial loss, this premium calculation is applied to both high-claim
members and law-claim members. Even with the flexibility afforded by
rating bands, the fact remains; even the healthiest insured with the
fewest claims will pay more for a product designed to reduce
uncertainty, trepidation and fear.
This article was adapted from
The California Association
of Health Underwriters 1991
Consumer Education Handbook,
© 1990 and 1991, edited by
Alan Katz, RHU and Kate Kinkadge,
CLU. Statistical information has been
updated if available or added where applicable.