Operating Business Model of the Insurance Industry
When you take your car into the mechanic you know you have some weird clunk and they have some way to diagnose the problem. Mack may be covered in grease, but he’s a solid guy. He gives you a deal on the parts and you pay the bill. You are headed down the road. You paid for a service. You have something in return. From Mack’s end, he has to calculate in the labour and price of the part. He makes a cut. He keeps the doors open.
When you need a book, you may surf the net. You may go down to the local bookstore. You pick out your next cherished tome from your favourite author and spend the money. You get your product. The publisher has to figure in all the cost of getting the book into a form you will buy and then factor in a margin. You get the book. They make a cut. They keep the doors open the next day.
So what do you get when you buy insurance? What are you buying? You are buying the chance that a problem will pop up. The beginnings of insurance had two sources. One was purely mercantile. One was an effort to help the community. The deepest origins of insurance came when sea voyages were a highly risky venture between weather and pirates in the 1600’s.
Financially merchants wanted to mitigate the chance of loss. They would get financial backers to “underwrite” the voyage. If the voyage had problems then the underwriter had to pay out to the merchant. If the voyage went off without a hitch the underwriter didn’t pay. So what was the advantage to the underwriter? They figured out some level of a risk/reward analysis so that the merchant paid a “premium” for the money. If nothing went wrong they made money on the probability of an event that didn’t occur.
The other systems were more grassroots. When a group of African Americans worked in a company town in Iowa in 1887 they pooled their money. Members would pay $1 into a pot once a month. If a member got sick they could access the fund to pay for the doctor. What is happening now?
We have some blended version of the two models. The thing is that the mentality of the mercantile has taken over. With the advent of the actuary, the industry has figured out how to maximize the risk/reward spread. From a strict mathematics standpoint they use maximization algorithms to figure out what generates the smallest amount of risk for the insurer with the largest reward.
Affordable Care Act
There is much debate over the new act, but these comments speak to how the act impinges on the current profit making practices of the insurance industry.
The centrepiece of the reform is how there is a mandate that the industry cannot deny people coverage due to a pre-existing condition. Why did this clause even crop up in the insurance industry? You have to keep at the forefront that industry is about capital protection and that comes in being able to control the risk/reward ratio. From John Graunt in the 1700’s first efforts what an actuary calculates is what type of disease etiology has a potential to create an early death.
An actuary works hard to calculate what disease will make a company the most money. If a person with a pre-existing condition has to be insured then the company loses its power over the probability. The statistics make a distinct chance that the risk of dying from a disease will be a health care Hurricane Sandy in the profit margins of the insurance industry.
Minimum Standards of Care
A person that looks at statistics can only control so many risk/reward scenarios for a profit margin. At some point the algorithms around maximization and minimization have a place they top out, a point of diminishing return on the dollar. The way the industry coped with that is that when the actuary found that dollar amount they would simply put a cap on the consumer. They would only pay to the point that it did not cut into their profit margin. This is a distinct difference from their counterparts in the late 1600’s. They were building in the cap to their risk
They weren’t protecting the interest of health to the consumer. With this type of mandate from the government, these caps are removed. It won’t be that they can’t continue to make money. Their industry just won’t be able to control the same level of built in profit. The government just told everyone they have to have coverage. The insurance industry is just upset because they aren’t making enough money in the transition.