Understanding Different Types of Insurance

Pure Insurance vs. Newer Hybrid Amalgams

After gaining a basic knowledge in how insurance is structured and how it works. It makes sense to compare insurance in its pure and simple form to a form that is much more complex and complicated. The reason that health insurance, and health insurance reform is so complicated is that in this country it has gotten away from its roots of providing people a safety net against catastrophes but also now covers a wide variety of things as mundane as a doctor’s visit.
              The simplest form of insurance is life insurance. The purpose of life insurance is that if the policy holder dies that persons family will be ok financially. If a spouse makes $100,000 a year, and then suddenly dies leaving behind the other spouse with two kids and $100,000 a year less in annual income, those left behind are in for significant financial hardship. To make sure a death does not leave a family broke, people buy life insurance.
              Since the relative risk of someone dying is pretty low, large life insurance policies are incredibly inexpensive. For example about $200 per year, buys about $500,000 of life insurance for a healthy individual. Obviously with underwriting the premiums increase for smokers, obese and other risk factors.
              Life insurance gives us an incredibly simple view of insurance because it is an all or nothing scenario. The insurance company is either paying out or not, because someone either dies or doesn’t. This uncomplicated system, combined with market competition has led to incredibly affordable insurance.
Life insurance provides a nice comparison to two types of insurance that are much more complicated, and are good to look at together auto insurance and health insurance. Auto insurance is a useful analogous tool to health insurance because of its similar construction, but it has fewer moving parts and is easier to understand.
Auto insurance is similar to Life insurance in the fact that it is primarily designed to cover catastrophic losses. The two primary types of catastrophic events that it is suppose to cover is severe damage to a car (something in the thousands of dollar range, that you wouldn’t be able to readily pay for out of pocket) and damage to another individual (putting someone in the hospital for a few days, or worse). The hybrid function that makes it different from life insurance is that many people use it for minor or relatively minor claims, like fender benders and the like.
Because people use insurance to pay for minor incidents, and not just catastrophic events, insurance companies charge more in premium to cover those incidentals. That simple point right there is at the crux of any argument in terms of insurance reform of any kind and as we will later see health reform. The simple fact that the simplest economic principle of “there is no free lunch” applies to insurance in that the more that is covered, the more the premiums cost. What is covered, and just as importantly what is not covered by an insurance company relates to maximum pay out, deductible (there are other factors that will be discussed later).

Maximum pay out of insurance policies.
Any adequate insurance policy should have a maximum pay out that accurately reflects the needs of the individual. For life insurance the policies pay out should be about 7-10 times the annual income of the insured individual. This ensures that the amount of money paid to the family will be enough to compensate for the lost wage. It is obvious to see that if a doctor making $250,000 thousand a year has an insurance policy of $250,000, that it won’t last his family at the style of life they were enjoying before he died. Contrast that with a janitor who makes $25,000 a year. A $250,000 policy invested wisely would take care of his family in the event of an untimely death.
              When the maximum of policy is inadequate to deal with the amount of money needed for something, this is what is referred to as being underinsured. Underinsured individuals have insurance and pay monthly premiums, but the policies they have are not an adequate safety net in case of a catastrophic event. This is true of the minimum requirement for insurance for auto insurance.
              Auto insurance in the state of Missouri has a minimum requirement for what drivers carry. That minimum is $10,000 property, $25,000 bodily harm, $50,000 total accident. That means if someone who is driving with minimum insurance totals your car, the maximum you can recoup from their insurance company for your car is $10,000. So if you drove a new car worth $25,000, you are simply out of luck for that other $15,000. To recoup the fifteen thousand you would need to sue them, and then try and recoup from that individual personally.
              A lot of people who love to blame insurance companies will then argue that the insurance company should have to pay more than that $10,000 for your car. After all it isn’t fair that they totaled your car and you have to be out $15,000 grand. But the fact is that the insurance company sold a policy based on a maximum of $10,000 pay out for property.
The person who bought the policy’s premiums reflected that total payment. It is bad public policy to have people underinsured, but it is illogical to fault the insurance companies. The fault rests on state legislators who set the minimums. If the legislature decided that the minimum should be higher then insurance companies would sell policies based on those minimums all the while calculating the risks of accidents.

Deductable
              A deductable is the amount of money that an individual has to pay when an insurance pay out is made. The individual is responsible for every dollar until the deductible is reached. For example a $100 deductible for a $2000 car repair means that you have to pay the first $100, but the insurance covers the next $1900.
Where the deductable is set has two affects on the policy and the policy holder. The affect on the policy is that the larger the deductible the cheaper the premium. The affect on the policy holder is that if they are directly responsible for the amount of money (first party payer, versus third) it makes them more judicious in how the money should be spent.
              A high deductible decreases the cost of a premium because it essentially states that an insurance company is not going to be responsible for minor things that go wrong. If policy A is a $25 deductible for a car and policy B is a $1500 deductible. Policy A will have higher premiums than policy B. that is because the insurance company will now be responsible for paying for a litany of minor damages between $25 and $1500, and because that costs something, it will be reflected in the policy.
              The end result is that the person who has purchased policy A has less money in their pocket but a more comprehensive insurance plan, while the person who purchased policy B has more money in their pocket but is less covered. Once again it’s the basic principle that everything costs something, coverage costs money. The more coverage, the more it costs.
              There also becomes the important economic factor of who pays for what, and how judicious will a consumer be depending on what the deductible is. And this has to do with the difference between a third party payer and first party payer (this will become incredibly important when we delve into health insurance reform). Lets compare some minor incidents and see how it relates to the action taken by the individuals.
              Both policy holders have a accident while driving through a parking lot, while backing out of the grocery store they run into a light pole damaging their car in a superficial manner, but not structurally damaging the car. The auto-mechanic gives them an estimate of $700. Who is going to get their car fixed?
              Policy A holder will almost certainly get his car fixed. His burden of the $700 repair cost is only $25. What incentive does he have not to get his car fixed? Almost none financially. There is the slight disincentive of having the hassle of getting your car fixed, but besides that getting his car fixed is almost free to him.
              Policy B holder is looking at a repair bill of $700. Since his deductible is $1500, it won’t come into play at all. Policy B has to decide whether or not $700 is worth fixing his car over. It is easy to conclude that people who hold the B Policy are far more likely to let small things on their car go with out being fixed.
              Most people who are unfamiliar with insurance will then conclude that the people who hold Policy B are getting a raw deal that it is unfair, or that Policy A is by fair the better policy. This is a natural reaction, although an errant one. The people who purchased Policy B are paying less in premiums than the people who purchased Policy A. And while the coverage is different, and it would not be an error to say that Policy A is ‘better’, it is better but it also costs more. Coverage costs money, and more coverage costs more.
              Understanding these basic principles is key, because they are the components of health care and health care reform. The issue of costs (aka premiums) will relate directly to deductibles and maximum health payouts. We will have to keep in mind that the more comprehensive the policy the more expensive. And if policies become too prohibitively expensive, people become unable to buy them. The role of deductible and ownership of health and decisions about costs will also be explored.