Health Insurance and Medical Risk

How Insurance Manages Risk Generally

Whenever we purchase insurance for something to protect against an event or events, insurance companies do their best to manage their risk and price our policies in accordance to what the overall expectation may be.

The idea behind this is for them to do their best to ensure that any contracts they enter into will have an expectation of profit. Whenever this is not the case, this would not make sense for the insurance companies, and they would seek to raise the premium for the insurance to bring it up to a level where it covers the expected payout, their business costs, as well as providing a satisfactory margin of profit.

Health Insurance and Medical RiskInsurance companies do not have complete information as there are a lot of factors which affect the probability of insured events or perils occurring that they do not have access to, but they do their best to use statistics to come up with a good idea of what their risks and expectations are and price their policies accordingly.

In looking to assign these factors, insurance companies look at the overall risk of the market, and then drill that down by taking into account factors particular to the individual client which may alter their risk from the mean. This works both ways and those who present less risk will generally pay less for the insurance, with higher risk individuals either paying more or not being insurable at all when the risk is perceived to be too high.

Risk can always be priced, but what happens when it is too high is that insurance companies simply do not want to take on situations where their risk to reward ratio is too high. Insurance companies are in the business of managing risk and this is what they focus on primarily, and will even hedge their risk over and above the risk management they use with their own policies by buying insurance against it from other insurance companies called re-insurers.

How Insurers Manage Medical Risk

There are a lot of statistics that can be used to manage medical risk, although there is still quite a bit of uncertainty involved as there generally is with any insurance. Insurers look at the risk of something overall as their starting point, and then look to further refine their risk analysis according to an insurer’s individual situation, if possible.

When one buys an individual health insurance plan, an individual risk analysis will be performed, and there are many questions that can be asked that can refine this. One’s medical history also factors into the equation a lot and medical insurance is one area where we do have a lot of data generally that can be considered and factored into price.

Even with individual policies, this can’t be managed as well as insurance companies would like due to changing circumstances affecting risk and it not being priced in to prior negotiated rates,

A lot of the time though, people will be covered through group plans and this severely limits the ability for insurers to price individuals accurately. What we see instead is their pricing these policies according to the mean and those with a higher risk than the mean benefit from lower prices and those with a lower risk pay more than they would otherwise.

Even if the costs of the insurance are borne by one’s employer, it is still important to realize that if you are paying more than you perhaps ought to due to your lower risk profile, this is harming you in theory anyway, although group policies do benefit from significant discounts over what it would cost you if you bought the same coverage individually, so this isn’t as big of a concern as it may appear to be.

With publicly funded health insurance, individual risk doesn’t even play a role in any of this, as there are few restrictions and the overall cost of the program is borne by taxpayers according to the amount of tax they pay.

In this system, your contribution to health insurance is in direct proportion to your income, where low income people will pay very little because they pay very little tax, and those who earn more will pay a lot more.

This makes sense since this is in essence a social program, and social programs involve collecting from people according to their ability to pay, with no regard to the particular costs and benefits involved with them. This does mean though that there are no real controls in place on an individual level, beyond government agencies setting reimbursement amounts.

This is also the case with group health insurance provided by private insurers. In cases where the employer offers the coverage themselves, they will bear the risk and if it is farmed out to an insurance company, as it often is, they will be left to deal with the ultimate costs and will need to make sure that what they take in exceeds what they take out by a desirable enough margin.

In this case, the risk is being managed by the insurer in the aggregate, which seems reasonable enough until you consider that, by doing it this way, we lose quite a bit of efficiency.

If the goal is to price each insurer according to their own risk, when we use large numbers like the very large groups that a lot of policies cover, while the overall numbers will generally come out looking good for the insurance company, we may expect that the fact that there is no incentive for those insured to limit claims, this will cause a rise and a pretty big one at that in the amounts that are paid out.

How Group and Social Insurance Increases Risk Overall

If this were more like car insurance for instance, where people realized that the more they claim, the more they pay, this would serve to restrain people from overusing the system. If the claim was very large, these claims would result regardless, but people would be more likely to want to pay for the smaller and more manageable stuff if it impacted their rates.

The way that group medical insurance is structured though, this isn’t really possible, as those covered are insulated from the costs of it and left unaffected regardless of the amount that they claim. If the cost of their policies goes up, their employers will have to pay it, and while this may take away from future increases in compensation to their people, this is not made transparent at all and employers actually wish people to see this as a pure benefit.

In this case, people will look to claim whatever they can and object if a certain medical cost is not covered by their policy, as they perceive the coverage as being free to them at least.

Those at higher risk will end up costing the insurer more, but more notably, those who use the system more will represent more risk as well. With group coverage, everyone uses the system liberally, and this serves to raise the overall costs to the insurer and therefore the risk.

Whenever insurance allows for purchases to be made that would not be made otherwise, this artificially increases the demand for it and also increases the price as a result. If the expected payout of a group plan or all insurance in the aggregate goes up, the price of policies must go up as well in turn, and having the medical risk overall of each individual covered under a plan not really having an effect upon usage does serve to increase the risks and cost of the insurance significantly.

This is even more the case with public health insurance, as there is no connection whatsoever between one’s contribution to the costs of the program and one’s behavior, as this is all pure entitlement and will certainly serve to have people use the system as much as they desire, and usually desire even more.

How This Might Be Improved

The closer we can get to having the consequences of the usage of health insurance matter, the better costs will be managed due to the reduction in over-usage that this will cause.

It simply is not efficient to have insurance policies cover events that are manageable, or have people want to choose treatment plans that are more cost effective. People will tell you that they want the best medical care available and often this ends up meaning more expensive treatments over less expensive ones, although the cheaper ones may be sufficient and even superior.

When we speak of medical risk to insurers, we mean not only the risk of very expensive events occurring, but the risk of escalating payouts in general. If an insurance company’s costs go up, it doesn’t really matter where the increased claims came from, because this all needs to be paid out and accounted for.

People complain when they have to pay out money out of their own pocket to partially bear the cost of a claim, or in some cases bear the entire cost if the threshold is not reached, and don’t really understand that this is generally to their benefit.

This is seen as even more objectionable with public health insurance, where people view this insurance as a right and the right involves not having to pay anything for conventional medical care. Any payments that are made here is seen by many as eroding the social fabric, especially among those who may find hardship in making these payments.

It is important for people to have a stake in all of this even with publicly funded coverage, as this has been shown to reduce costs by quite a bit by limiting unnecessary health care spending or at least getting it to the point where it would be considered to be reasonable.

The lack of transparency with both group plans and public ones is a big issue but when you have people completely insulated from their activities having any negative financial implications then that’s an even bigger problem and challenge.

At the private level, we ideally would have participants not only bearing part of the cost of their medical expenses, but also have them potentially contributing to the cost of the insurance themselves.

If employers paid out a base amount of it and then individuals were assessed and priced individually, with their having to come up with the difference in cases of higher risk, either by way of risk factors or usage, then we’d actually have an incentive for people to manage their own risks and allow the system to operate much more efficiently.

With public insurance, there are already controls on spending in place it does not serve to restrain usage, and having patients contribute part of the costs personally is required to control over-usage.

It would also help to provide data to people as far as how much this so-called free health insurance has cost them, as a percentage of the taxes they paid. With this in place, we would be in a better position to enact reforms which look to reduce costs rather than just having people demanding for more and more because the costs of this to them are at least more out in the open.

Health insurance in today’s world is plenty important, but we need to remember that this all comes at a cost to us one way or another, and by allowing insurers to manage risk better and reduce their costs, we end up benefiting as well.



Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

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