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.


  1. This a very clear general overview of the foundations of insurance. I am interested in knowing the specifics of health insurance cooperatives.

    How do health insurance coops differ from for profit health insurance organizations?

    Do not for profit health insurance coops actually save participants premium costs by simply being in the competition for cosumers?

    What is the advantage of participation in one or the other to the consumer?

    How does a "public option" government supported system differ from the for profit and not for profit systems?

  2. This seems to be the number one question on everybody's mind. I am familiar with rural electricity cooperatives, homeowners' associations, and credit unions. What is being considered in congress may not be like these familiar co-ops.

    To answer your first question: It seems that health insurance co-ops are intended to be non-profit, meaning that any excess return (whether on premiums or investments) stays in the co-op. It can then be used to increase investments (and hence, investment income), which put downward pressure on premiums over time. Or the profit can be used to rebate a part of premiums to policyholders. Finally, it can be used to reduce premiums the following year(s). In short, the excess money that comes in goes to benefit the people who paid it in the first place.

    Second question: Co-ops can put downward pressure on premiums by adding competition to state markets that have restricted competition. (See my post for Part 2, Why is Medical Insurance Different?) However, if their rules require them to take all-comers *and* premiums are capped below actual cost of insuring a significant percentage of policyholders, then there will be upward pressure on premiums. The rules will determine how premiums actually move, and so the numerical impact on premiums is hard to predict.

    Third question: If competition is vigorous, then the co-op should have the advantage, as it retains all of its earnings solely for the benefit of its members. The for-profit company might still stay in the ballgame by accepting more risk with its investments in order to generate more income to offset premiums.

    Fourth question: If a co-op has an implicit guarantee of a rescue by the federal government, such as occurred with Fannie Mae and Freddie Mac, and if the seed money comes from the federal government with too many strings attached, then the co-op will not compete on an even playing field, and will be indistinguishable in the long run from a publicly provided insurance option.

    The overt public option is at open risk of requiring taxpayer bailouts/subsidies, which again alters the competitive environment to the advantage of the public option. This would likely drive the middle class out of private insurance and into the lower-cost public option. Private insurance would still remain (if allowed by congress) to care for those who want insurance better than the public option, and are willing to pay more. I suspect that the co-ops would be gutted in such a situation, and that the for-profits would provide the remaining private insurance, but be much smaller companies.


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