Healthcare and Insurance (1)

Americans are really stirred up about medical insurance and healthcare.

America began with a charity model of health care. I do not know the history of how it changed, but the charity model turned into an insurance model. All that remains of the charity model is a few hospital names pointing back to a more generous past.

Some Americans are now arguing for a single-payer system.

To understand the problems with the insurance model, we need to understand the nature of risk.

Pooling Risk
Understanding and managing risk has become a bit of science. Risk has two parts.

1. Likelihood
2. Impact

Likelihood tells us the probability of an event happening. Impact tells us how much harm the event will do. The two factors are combined for an assessment of risk. An event that is highly likely is not a problem if it has no impact.

Insurance is a method of pooling risk to minimise the cost of rare events to any one person.

Insurance works well for situations where the risk has low likelihood, but high impact. For example, the likelihood of a person’s house burning down is quite low. However, the impact is enormous, if it does happen. House insurance is a method for pooling the risk and the costs.

In a city with a thousand homes, only one homeowner might experience a catastrophic fire in their house in any year. If everyone who lives in the city pays into an insurance fund, each homeowner will only have to pay one thousandth of the cost of rebuilding a home to give the insurance fund enough money to pay for the cost of replacing the one house that is burnt down. Homeowners have several good reasons for paying into an insurance fund.

• No one knows in advance who will have a fire. It might be me.
• The cost of a fire would be devastating for the family whose house burns.
• The cost of the insurance is relatively cheap.
• The probability of a house going on fire can be estimated by looking at the history of house fires.

Insurance deals effectively with risk like a house fire, because it is relatively rare. The insurance company is able to estimate the probability of fires occurring and calculate an appropriate level for premiums. Everyone benefits from sharing the costs of the fire, because they know that next time they could be the one facing a tragedy.

When the cost of a claim is extremely high, but relatively rare, and there is a significant uncertainty about when and where the risk will strike, it makes sense to spread the risk. Insurance is a method for pooling risk.

Insurance works well for house fires, because the likelihood of a house going on fire is the same for everyone. Therefore, pooling the risk makes sense provided your insurance company does not cover too many people who smoke in bed or keep a can of gasoline in their cupboard for huffing.

I will apply these principles to health insurance in my next post.