In my last post I discussed various types of insurance and likened the decision to buy insurance to placing a bet with the insurance company as a sort of casino. Just like a casino must balance the odds to assure its profitability, an insurance company must understand the likely cost of each risk in terms of the benefits it will have to pay and set its premiums accordingly, not too little that it goes out of business but not too much that it gets no business.
There is a perception that insurance companies have a lot of money, and this may well be true. Most of them are businesses with stockholders, and after payment of benefits, operating costs, and taxes have to make a profit to survive. While meaningful price comparison may be difficult, they do compete with other insurance companies and to some extent business will flow to the insurance company offering the coverage that customers are convinced they want for the lowest price.((What coverage is actually needed can be a far different question and one well beyond not only this post but any that I currently contemplate.))
There are other tools that insurance companies can use to control their risks. For many types of insurance the insured is responsible for a “deductible,” usually a fixed dollar amount of each claim (or aggregate of claims for the policy period) and/or a “co-payment,” whereby the insurance company will only pay a specified percentage of a covered loss.((Because higher deductibles and co-payments should mean lower premiums, they are also a way that the insured can fine tune the balance between costs and coverage to match her own risk tolerance.)) An insurance company can also obtain its own insurance policy for part of its risk; this is called “re-insurance.”((As some policy holders of the failed Mutual Benefit Company learned, reinsurance policies benefit the company (and its policy holders generally when it is insolvent) and not the holders of any of the polices that are reinsured.))
Insurance is also a highly regulated industry, and the government will often require policies to provide a certain level of benefits. Such requirements will likely either increase the premium or lead the insurance company to reduce benefits elsewhere. Although such requirements do certainly limit consumer choice, the insurance company can take them into account when setting its premium rates. Sometimes, however (always in the public interest, of course), the regulator will mandate the payment of benefits beyond those for which the policy provides during a policy term. I believe that health insurance companies were required to provide extra benefits in connection with COVID-19 and following Hurricane Sandy New Jersey prohibited insurance companies from charging a higher “hurricane” deductible for which their policies provided.
Insurance companies rely upon actuaries to calculate the risk of various perils in order to determine the appropriate premium. Changes in the regulatory environment during the term of a policy can lead to a situation where the risk in increased beyond that which had been computed and therefore the premiums (which the insurance company cannot change during the policy period) are insufficient to the risk, impairing the insurance company’s financial position to a greater or lesser extent. Every dollar in increased benefits requires an offsetting dollar of reduced expense or increased revenue somewhere.
The pricing of premiums relies upon the ability to predict accurately the expected payout for the aggregate of the risk the insurance company assumes. Actuaries may determine what characteristics of an insured make a particular peril more or less likely to occur, or more or less expensive if it does, but they do not, at least generally, predict risk at the policy holder level. The risk of a payout on a health insurance policy is, on average, less with a younger insured than an older. An insurance company that ignored the actual risk in order to price health insurance premiums lower for older policy holders would end up charging younger policy holders more than their actuarial fair share and lose them to a competitor. Such a company would likely attract a greater share of older policy holders.
While some knowledge of the risk being transferred is essential to the basic idea of insurance, too much knowledge is fatal to it. If the insurance company had a crystal ball that enabled it to predict accurately the cost in terms of benefits to be paid for each of its customer, it could more accurately price its premiums. But, because the premium is pretty much equal to the risk assumed, there is no risk transferred and the reason for insurance in the first place is would be obviated.
What automobile insurance customer would not increase coverage and/or reduce his deductible if he could do so retroactively after an accident? If you did not have health insurance and learned that you had a condition whose treatment was likely to be quite expensive, wouldn’t that change your cost-benefit analysis of whether to obtain insurance?((Stick a pin in this; I plan to discuss the feature of the Affordable Care Act that mandates coverage for preexisting conditions in the next post.))
Jay Bohn
August 5, 2021