Thursday, August 20, 2009

Health Insurance Facts, Part 2: Why is Medical Insurance Different?

Link: Health Insurance Facts, Part 1

I have been brooding over the question of "Why Medical Insurance is Different" for many days now, trying to get succinct evidence to share. I have found it, and will present it shortly.

Medical insurance seems to have been first considered in 1694 [1], and first introduced into the United States in 1850 [2]. It was intended to cover injuries due to accidents, and seems to have been related to modern disability insurance. Sickness insurance followed in 1890, and employer-sponsored group disability insurance was first issued in 1911. [1]

Hospital and medical expense policies were introduced during the first half of the 20th century. During the 1920s, individual hospitals began offering services to individuals on a pre-paid basis, eventually leading to the development of Blue Cross organizations. The predecessors of today's Health Maintenance Organizations (HMOs) originated beginning in 1929, through the 1930s and on during World War II. [1]
The wage controls imposed during World War II are often cited as the leading cause of the importance of employer-sponsored medical insurance. With companies unable to offer greater wages to their workers by law, they turned to fattened benefits in order to compete for talented workers. Medical insurance policies covered more things as a result. This was fine for those individuals and families whose employers provided such benefits, but did no good for those employed elsewhere, such as by small businesses unable to afford such benefits, or unemployed (whether voluntarily or not).

Enter the states. Before I describe insurance mandates, let me take a moment to address the question of federal regulation of interstate commerce of health insurance.

The Health Care Choice Act, a bill introduced unsuccessfully into the House of Representatives in 2005 and 2007 has attempted to allow medical insurance to be sold across state lines, amending the Public Health Service Act (42 U.S.C. 300gg et seq.). I need more time to determine whether sections 300gg et seq. prevents interstate commerce with respect to medical insurance policies, but I think it is safe to say that if a bill in Congress is attempting to achieve the opposite, then it is safe to assume (for this article) that Congress has in fact prevented it.

Therefore, states have a monopoly on the chartering and regulation of medical insurance companies. Large insurers compete in states by creating (or acquiring) a subsidiary in the state in which they wish to do business, but all policies therein are unique to that state, even though the subsidiary is financially backed up by a multi-state parent insurance company. This type of organization raises the costs of entering the market in another state, and is therefore a barrier of entry to competition, and is one factor in the oft-cited fact that a few large insurers dominate the market in many states.

Add to this barrier of entry the manifold regulations by the states of what must be in policies. The Center for Affordable Health Insurance has catalogued 2,133 policy benefits mandated by the states in a 2009 report (pdf). (These 2133 mandates overlap considerably.) The report shows the mandates by state, and estimates the contribution of each mandate to the cost of the state's required policy. This means that medical insurance has evolved, under employers' hands and the state governments' hands, into something more comprehensive. What was once known simply as Accident Insurance, then (over time and as coverage increased) Hospital Insurance, Major Medical Insurance, and just plain Medical Insurance, now is known as Health Insurance, covering arcane things such as contraception and AIDS testing.

The method of payment for claims has also changed considerably over time. Insurance policies were once "indemnity" policies, meaning that we submitted our own claims and were reimbursed afterwards for whatever was covered. Later, insurance companies formed Health Maintenance Organizations (HMOs) and Preferred Provider Organizations (PPOs). In HMOs, the insurance companies own and operate the means of providing care, and employ the doctors and nurses. In PPOs, the insurance companies negotiate fees with the providers, and do not necessarily own the means of providing care. In HMOs, we pay whatever is not covered by our policy, and there is no extra paperwork between the provider and the insurer. In PPOs, the provider generally bills our insurer on our behalf, and collects the difference between what is covered and what is not directly from us. Preferred providers go a step further by waiving any part of their usual fee not allowed by the insurer (due to fee negotations). In short, we have become separated from the costs of care, because we no longer bear the full cost, no matter how temporarily, because the providers and insurers float the costs through their accounts payable/receivable. We once did the paperwork with the insurer for free; now we (or rather, our insurer) pay the provider to do it on our behalf.

I am forced to conclude that medical insurance is different from auto insurance and home insurance because we the people, ostensibly through our employers and elected representatives, have chosen it to be this way, for better or worse.

Friday, August 14, 2009

Wednesday, August 12, 2009

Quote of the Day: Health Care

"Health insurance companies refuse to cover pre-existing conditions for the same reason that you can't insure your automobile after you crash it." --Robert Tracinski, Real Debate Is Individualism vs Collectivism

The article is excellent throughout and pre-figures my Part 2 for understanding Health Insurance.

Saturday, August 8, 2009

Quote of the Day

"The founding of this country was the result of a tax revolt."

--Breck Collingsworth, a Wall Street Journal subscriber, commenting on an article about Town Hall revolts in Maryland.

Perhaps those in the White House and in Congress who wish to tax us more (and more "progressively") should better remember our nation's history.

Monday, August 3, 2009

Health Insurance Facts, Part 1: What is Insurance?

On July 24, protesters picketed the Richmond headquaters of Anthem, a subsidiary of WellPoint, a national health insurance group. One of my relatives was among the picketers.

Before dinner the next evening, I had the opportunity to speak with my relative concerning the protest, and I discovered that certain facts had been asserted, and certain negative opinions had been formed. I recommended that she examine Anthem's financial statements, freely available online from the Securities and Exchange Commission, and to especially read the Management's Discussion and Analysis section. Not only does this check the asserted facts, but it puts the protester into the shareholder's and manager's perspective, inviting them to see the real constraints encountered in the health insurance industry, but also challeging them to think of what they would do better, and if that is the real substance of their protest.

I want to provide first a general discussion about insurance and learn what I can without deifying or demonizing any particular company. Second, I want to understand better why medical insurance (AKA health insurance) is different from other types of insurance. Third, I want to examine the real financial statements of a large health insurer and understand what events are occurring and what choices management is making.

Let us begin by answering the questions, Why do we have insurance, and what is it? In the simplest approach to insurance, one person who is going to perform a risky activity (the insured) contracts with another person (the insurer) who is willing to accept the cost if an adverse outcome occurs. The liklihood of the adverse outcome is usually low, and the cost is usually very high. The insurer charges an amount (proportional to the risk) for the insurance (the premium) and sets it aside until the insurance contract expires. If the adverse outcome occurs, then the insurer covers the cost, usually more than the value of the premium. If the adverse outcome does not occur, then the insurer profits from the premium, and the insured endures an additional, unneccessary in hindsight, cost of doing business.

One early use of insurance was to protect the owners of shipping vessels. Then, as now, shipping goods over the sea was a risky enterprise. The loss of a vessel was a real and substantial threat to the solvency of a shipping company. Those with money to invest would insure the shipping companies. If an insured ship was lost at sea, the insurer would compensate the owner for the goods and the vessel. Since the amounts at stake were so large, syndicates of investors would be formed for the duration of the insurance contract, and these syndicates would provide the necessary financial backing. By syndicating the risk, the value insured could be much larger than any single investor might be willing to lose.

It might seem that the insurer's profit can be quite large when the adverse outcome does not occur, but if you repeat the insurance contract over and over again, the insurer will pay according to the likelihood of the adverse outcome, and profit the rest of the time. A smart insurer will therefore set the premium large enough to break even over the long run, plus a bit more for the remaining uncertainty. The lesson here is that large insurance profits in one time period are no guide to the morality of these profits over the long run.

An extension of the single-event insurer is the cooperative insurer. The non-profit version of these insurers, often called mutuals, exist for the benefit of their members, and are often owned by their members. For-profit versions are also common, and transfer the risk of loss away from the policyholders and onto the owners of the insurer. The latter type is most familiar to us, having names like Allstate, Geico, Wellpoint, and Aetna.

The idea behind the cooperative insurer is that adverse outcomes do in fact occur over the long run, and that it is prudent to save over the long run in order to offset the eventual cost of these adverse outcomes. Ideally, all of our adverse outcomes would occur after we have had a chance to save for their costs. The reality is that it usually happens before we have saved enough. By joining together into a cooperative, we increase the likelihood that we will have enough resources to cover every individual adverse outcome, because the likelihood of them happening in large enough clusters in short periods of time in a way that exceeds our collective savings is very low. We benefit most when we are all long run members of these cooperatives.

The modern financial markets provide the insurer with an opportunity to turn these collective savings into investments that earn income. This income can then be combined with premiums to cover the costs of adverse outcomes (or claims). The greater the savings cushion, the greater the investment income, the lower that premiums need to be. The basic equation for an insurer is quite simple:

Investment Income + Premiums = Claims + Fraud, Waste, & Abuse + Overhead + Profit (or Loss).

(Reality adds more variables to each side, but the concept is unaffected.)

Profit is used in two ways: to reward the owner of the insurer for bearing the risk of loss, and to increase the amount of savings earning investment income. Loss reduces the amount of savings, and hence the investment income. (In a mutual, there is only the increase in savings when the insurer profits.)

Now there are some general points to draw from this model of an insurance company.

1) If claims exceed premiums and savings, then the company is insolvent.

2) If investment income falls, then premiums must rise.

3) Fraud, waste, and abuse, and overhead must be controlled if the insurer is to profit, and therefore leave its savings intact.

4) In a for-profit insurer, the owners provide the initial capital that funds overhead and claims until premiums and investment income are sufficient over the long run, and own the increases in the insurers savings.

Next: Health Insurance Facts, Part 2: Why is Medical Insurance Different?

EDIT: Added link to Wellpoint's financial statements at Edgar.

EDIT: Clarified for-profit cooperatives by providing named examples.

NOTE: About my use of the word "cooperative" in this article, I use it in a conceptual way, rather than in the manner of a legal organization. The article's concept of a cooperative is as a long-run, multi-participant insurance construct, as opposed to a single insurance contract between an insurer and an insured. I'll cover the legal organization in a later article. I suggest this article and this organization as starters.