Principles and Economics of Health Insurance - Part 2

[Editor’s Note:  Discussions on Medicare, Medicaid and health care plans in general are dominating the political and economic news.  The impetus is (1) the runaway costs of medical care and (2) the lack of sustainability of the current Medicare and Medicaid models.  All of this revolves around health insurance, but a perusal of the discussions shows that a large majority of those talking either lack basic knowledge of health insurance as a risk management concept, or are so misinformed that their comments border on the ridiculous.

As a result The Dismal Political Economists has written a series of posts which will explain the basic economic principles behind risk management and insurance, in the hope that while he does not expect agreement on the various points of dispute, at least the parties may be able to come at the issue with a basic understanding of the dynamics of the issue.]

In Part 1 this series explained the demand for insurance.  It showed that when there was the possibility of an adverse event, E with an expected loss of L, and a probability of the event occurring as P(E), that when L was very high and P(E) was very low a market for insurance against the risk could take place.  Those exposed to E would be willing to pay  a fixed fee to someone else who would assume the risk that those exposed to E would have.  Those willing and able to secure insurance are referred to as the Insured.

However, just because there is a demand for a service, in this case insurance, does not mean that insurance would be provided.  The question for this part of this series is why would an Insurer enter the market and provide insurance.  After all, after the transaction takes place the Insurer has assumed the risk, and that risk is not changed by having a different party subject to the risk.

The reason that an Insurer would provide insurance is that if the adverse Event does not occur, then the Insurer can keep the amount paid to it to assume the risk, this amount being termed the Premium.  This Premium represents 100% profit (after administrative and other operating costs of the Insurer).  Thus the Insurer is entering into a type of wager, and the Insurer is betting that the adverse Event will not happen.  As shown earlier, since the market for insurance can only be created when the P(E) is very low, this might be a very good bet.

As an example, consider the origins of insurance, the need to protect those shipping goods by caravan, from a catastrophic loss.  If the Caravan is made up of 10 shippers, each shipping goods worth $5,000 each, and an insurer is willing to insure each shipper for a premium equal to 5% of the value of the goods, the Insurer would charge $2,500 to insure the entire caravan.  If the caravan makes it to its destination intact, then the Insurer has made a profit of $2,500.

So in this example, if the Insurer knew that say 98 times out of 100 this type of caravan arrived safely, meaning there was only a 2% chance that the caravan would not make it and the Insurer would have to pay out $50,000, does this means a single Insurer would want to insure the Caravan?  The answer to this is no. And that leads to the next issue in understanding insurance, Risk Management.