Medical Insurance Magic: Why does it exist in the first place? (Part I of IV)

According to a recent report, insurance companies are going to pay back $1.3 billion as rebates for "overpayment" of health insurance policies. Should we all jump up and down and yell, "Whoopie?" Not just yet.

health insurance pros and cons

Further reading reveals that the average holder of an individual policy will get a $127 rebate. Those of us insured by our employer will essentially receive nothing, since the employer will get the rebate. So I don't think this is going to significantly impact the real cost of health insurance.

Buying insurance is, let's face it, a form of gambling. I am well aware that this statement runs counter to everything you know and believe, but follow my reasoning.

At a basic level, any time you buy insurance you are placing a bet. When you buy automobile insurance you are betting you will have a collision. When you buy life insurance you are betting you are going to die. When you buy health insurance you are betting you will become ill and incur medical bills. Now, you may counter, that can be a pretty good bet. After all, the chances of getting into a collision with your car sooner or later are reasonably high, even if you are a good driver. There is also, unfortunately, a significant chance of incurring health care costs, and the odds of (eventually) dying are 100 percent.

So why would insurance companies be willing to take these bets? Because, just like in a Las Vegas casino, insurance companies have carefully figured the odds and arranged a significant "house advantage." They employ actuaries who calculate the odds based on population data.

Although it is very difficult to know when any particular person will have a car accident, fall ill, or die, it is exceedingly easy to predict how many times this will happen for large numbers of people. Through the "magic" of actuarial statistics, insurance companies can predict the odds with relatively great accuracy and price their policies accordingly. After all, they are not betting that these things will never happen, but that they will on average collect more money in premiums than they will have to pay out when they do.

Insurance companies have another inherent advantage, known as "the float." From the day they collect your premium until the day they have to pay it out in benefits, they invest that money. So if I pay $1 in premium today and get $1 back to cover my insured expense at the end of the year, and the insurance company earns 6 percent on that $1 over the course of a year, they get to keep 6 cents. This doesn't seem like much, but what if we multiply it by 100 billion dollars? Now we're talking about $6 billion in profit, just for holding the money. This is the further "magic" of large numbers.

So if the insurance companies have this great inherent advantage, and insurance is such a "bad bet," why should we buy health insurance at all? This is exactly the argument that many of the 45 million uninsured Americans make when they forgo the purchase of health insurance. Some calculate that they are better off to use the money to buy food or pay rent.

We'll address this argument in Part II of our series on medical insurance magic.