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 prosperity."

-Andrew Tobias,
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 health insurance.

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 benefit?
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 surplus.
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.

Why Premiums Increase
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 percent.
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 their plans.
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.




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