We rarely have to ask how car insurance or home insurance work. What is it that makes health insurance so much more complicated — with individual mandates, single or multiple payers, and so on? Since Congress is (once again) talking about changing how health care works in America, it may be a good time to explain what makes it so strange.
This thing we sometimes call “health insurance” is actually a fusion of three different things, only one and a half of which are “insurance” at all. I’m going to walk through the basics you need to know, and end up with a set of four questions you can ask about any health care proposal that will let you understand what people are really talking about.
(I’m not going to tell you what I think the right answers are, though. This article is to help you ask the right questions — and I’m interested in your answers.)
Let’s start by talking about what insurance actually is. The first modern version of insurance was invented in the Netherlands in the 1600’s, when people were finding that sending a ship on a trading voyage could be very profitable. The good news was that you could make back the whole cost of your investment (a ship, a crew, some things to start trading with) in just a few voyages; the bad news is that a lot of voyages also ended up with shipwrecks, which would take your entire investment to the bottom of the ocean.
Let’s say for simplicity that it would take you ten voyages to make back the cost of a ship, and one voyage out of twenty got shipwrecked. Suddenly, your life depends a lot on luck: if that shipwreck happens on your eleventh voyage, you’ve got enough saved up to buy a new ship and keep going. If that shipwreck happened on the tenth voyage, though, you were screwed.
Pretty soon, some fairly wealthy men figured out a way to fix this: they would offer an “insurance contract,” where before each voyage, a shipowner would pay them one-twentieth the cost of a ship plus a fee, and if they were shipwrecked, they would get paid the full cost of getting a new ship. Both sides came out happy: on the average, the insurer was earning the fee for each voyage, and the shipowners had turned an unpredictable, possibly catastrophic, expense into a regular, predictable one.
This is the simplest kind of insurance: it takes a large (but known) expense that might happen at an unpredictable time, and splits it up into a lot of small expenses that you can plan for. Your homeowner’s insurance today is basically the same kind of thing.
There have been lots of improvements to this idea over the years. One that’s particularly relevant to us is actuarial science: the development of professional experts in figuring out the odds. In the story above, the insurer was charging one-twentieth the cost of the ship plus a fee, because he knew the cost of a ship and could estimate that one voyage in twenty shipwrecked. But if he predicted those odds wrong, he could be in trouble: too high an estimate would mean he was charging people too much, and they would go to his competitors (often just a few tables down at the café). Too low an estimate, and he’d be paying out more than he collected in premiums, and could go bankrupt within the week. So hiring a lot of clever people to figure out just how likely these events were became very important.
One of the first things actuaries realized is that not all voyages are equal. A trading voyage from Eemshaven to London is a lot less risky than one to Shanghai. A well-crewed boat in good repair is less risky than one that looks like it may sink if someone sneezes too loudly. An experienced crew is safer than a green one. This means that insurers could — and should — charge different voyages different rates. The perfect insurance contract is one where everyone knows the exact odds of something going wrong.
Each of these cases has something in common: everyone knows and can agree upon the price of the thing being insured. But sometimes, you want to insure against something that you know will be very expensive, but whose actual cost you don’t know ahead of time — say, the liability insurance on your car, which is insuring against the medical bills of someone injured in an accident. How does an insurer know how much to charge? And what if it’s a “catastrophic” event, one that ends up being so expensive that the total premiums that the person buying the insurance would never pay that much over their entire lives?