Insurance first started in Italy during the Renaissance. Merchant's dealing in the Far East needed a way to compensate them against problems associated with medieval long-range transport. I have long joked that the basic method of insurance is in fact a mafia invention. The policyholder pays the insurance company premiums, and the insurance company does everything it can to
not pay the insured. (Italy, mafia -
get it? It works better in person). Essentially, insurance was one of the first ways of dealing with risk. Today, there are numerous ways of ameliorating risk, but insurance is still one of the primary methods used by individuals and businesses. Below is a basic explanation of the nuts and bolts of how this arcane business actually works.
First, there is a very important idea of compounding. Let's say you take $100 and invest it at 10% interest for 10 years. The first year, you make $10 in interest, so your account total at the end of the year is $110. In year 2, your account will make interest on $110, instead of the original $100. This process repeats for 10 years. (BTW, you would make $259.37 on the investment). This process is called compound interest, and it is the benchmark of most financial plans.
Let's advance this idea one step further. Suppose a company pools a number of individual investments and then uses compound interest on the pool of funds. Instead of 1 person investing $100, we now have 10 people investing $100, or $1000 per year. So, in the above example, instead of having $259.37, we now have $2,593,74 using a simple compounding formula.
Let's go one more step. If you only had $100 to invest, you would probably invest in something pretty conservative, like a treasury bond or a blue chip stock. This means you probably wouldn't make a 10% return.
But now suppose you had $1000 to invest. You could invest some in a broader range of assets. If one investment didn't do so well, the other investments would make up for the loss. This is called
diversifying risk.
Let's look at this from the perspective of a life insurance company. Just imagine you are an insurance executive. You promise to pay a policyholder's family $100,000 when the policyholder dies. The policyholder pays the company a
premium -- a regular monthly payment. The insurance company knows it has to pay the policyholder $100,000 someday in the future. The insurance company wants to insure that it at least does not lose money on the transaction. Therefore,
they have an entire group of actuaries - people who spend their entire life computing the statistical probability of when certain people are going to die based on a wide variety of information. Based upon the actuaries' calculations of when various people die, the insurance company figures out how much it should charge the policyholder and charges the policyholder a certain rate. The actuaries
predict when the company will incur a liability -- when the company will have to pay the policyholder.
Life insurance is a very predictable business. Actuaries - for all of their nerdiness - are in fact damn good at predicting mortality rates of various people. As a result, the rate of failure of their calculations is smaller and smaller as time goes on.
Insurance companies invest in a wide-range of assets: stocks, bonds, options, real estate, currency etc.... The rate of return of these assets is a key ingredient in determining profitability. The management of these assets is key. Poor management will mean the company will go under, whereas solid management means the mix will at least be able to provide adequate liquidity to fund the companies' current liabilities.
Remember the compounding idea from above? Life insurance companies use this idea to maximize the returns of their investment portfolios. Because there is usually a long time between when they receive premiums and have to pay benefits, the life insurance company uses compounding to its advantage. This is why people who start to pay life insurance premiums at an early age usually have very low premium payments, and why those payments increase the later in life that someone starts to pay into an insurance policy.
The relationship between the companies liabilities (what the insurance company is contractually obligated to pay) and assets is referred to as an
asset-liability mix. The management of this relationship is an art in and of itself. Whenever you hear of an insurance company going under, you will probably see the term "liability heavy" somewhere in the article because the company most likely owes more than it has in investments.
The reason I described all of this is to mention why health insurance is so damn difficult for the private sector to manage. Let's compare a life insurance company to a health insurance company to illustrate the depth of the problem
The life insurance company is only insuring against 1 variable - death. The computation of the risk associated with this variable is remarkably standardized by now. The portfolio manager knows he his asset liability mix will be fairly stable and predictable. As a result, he is able to really focus on the investment portfolios long-term performance. He knows there is a very low likelihood of a massive payout occurring at anytime.
Compare this with the risk and higher degree of randomness with illness. There are literally
thousands of diseases to insure against.
And the probability of these various diseases happening changes all the time. For example, a younger person is not as likely to get Alzheimer's as an older person. But it can happen. As a result, suppose a younger worker who just started paying premiums gets Alzheimer's and is miraculously covered by his policy. The insurance is obligated to pay for the policyholder's treatment. But the policyholder`s premiums are nowhere near sufficient to actually pay for the cost. In addition, there has been insufficient time for the premiums to actually compound in any way. So, the insurance company has a larger liability than asset mix in relation to this one policyholder.
Now, let's compound the problem.
Suppose a large majority of policyholders contract medical expenses that are disproportionately expensive in relation to the premiums they have individually paid to the insurance company. The company is literally hemorrhaging money at this point. The correct financial term for this situation is
"financially fucked."
The above situation - although basic - illustrates the basic problem of health insurance.
The primary problem is massive unpredictability. Instead of having to pay a lump-sum in X years,
the company has less knowledge about when it will pay and how much it will pay. This situation has serioius implications for the management of their assets. The company needs more liquidity -- short-term assets (which usually have a lower yield or rate of return) because the possibility of immediate pay-outs is higher. This constrains the portfolio manager's investment decisions.
So, what is the answer? I have no idea. I am just beginning to get an idea of the size and magnitude of the health insurance problem in this country. The more I know, the more I realize how complex and difficult it really is.