How Health Insurance, and Insurance in General, Works

Health insurance is somewhat different from other forms of insurance.  Today I thought I’d discuss how insurance works, and how health insurance is different.

Most forms of insurance are used to reduce risk.  For example, let’s say that there are 100 homes in an area, all valued at about the same price.  The homeowners decide that if they had a fire, they would not be able to pay to rebuild their home since it takes them 20-30 years to build up enough money to buy one.  They therefore decide to each chip in some money into a pool that they could then use to rebuild homes if there is a fire.  They therefore eliminate the risk that they would need to come up with a lot of money at one time to rebuild their home.

The first thing they would do is to determine how much money they would need to contribute to cover the costs of rebuilding homes.  Let’s say that they look through data and discover there is a home fire that destroys a home about once each ten years, and that the value of each home is about $100,000.  The amount they would need to contribute is:

(Value of Home x Frequency of Fires)/(Number of Insured)

= ($100,000x 1/10 years)/100 homes = $100 per year

Now, there is a chance that they could have two fires in a year or have a fire relatively early before they had built up enough money to cover the expenses, so they may choose to increase that a little, maybe to $110 per home until they built up enough finds to cover a fire or two, and then reduce the premiums back down to $100 until there was a fire and they needed to replenish the funds.  If a fire occurred and their funds were depleted, they might raise the premium rates back up for a time to build up a reserve.

Note that everyone is actually paying the cost of replacing his/her own home as often as he/she was likely to have a fire.  He/she could also just save up the money and replace the home himself/herself if a fire did not happen for a long period of time.  There is a risk, however, that a fire could happen right away before savings had built up – hence the need for insurance.  If he/she had enough money in the bank to just pay to rebuild the home, he/she could just be self-insured and save the insurance premiums.

After a little while without a fire, the homeowners in the insurance pool would start to build up some funds in the pool.  Rather than just leave the money in cash, they might want to get a better return for their money.  For example, if they had built up enough to cover 5 houses – $500,000 – they might choose to invest $300,000 of the money in stocks where they could get a good return over long periods of time, keeping $200,000 in cash so that they could cover at least 2 home fires without needing to sell stock.  If the market swooned right when there were a couple of fires, they would still be covered.

An insurance company is no different.  They figure out how often a fire will occur and charge enough to rebuild homes at that frequency.  They also charge more for people who are more likely to have a fire, based on things like neighborhood and the age of the home, and based on how much damage they expect a fire at the residence to cost.  They therefore would charge more for homes that cost more, and less for homes that are close to fire hydrants and maybe those which have sprinklers and other measures to reduce the damage from a fire.  They also charge a little extra to pay for the salaries of the insurance company workers and executives, advertising, and other costs of running the insurance company.  If there is enough competition they will reduce these costs as much as possible to keep their premiums in line with those of the other companies.

The insurance company makes money by charging a little more than they pay out and by investing the money that they have stored from premiums during the periods between events.  If there is a big event they may raise premiums for a while to rebuild their savings to reduce the risk that they will not have the funds to pay for the next event.  If there are changes in their risk – for example, the value of the homes increases or there is an increased risk of fires because the town authorizes the use of fireworks – they may increase their premiums to cover the additional risk.  Likewise, if people start using the insurance more often, they raise premiums to cover the additional costs.

Health insurance is different.  In the past, what was called “major medical insurance,” which only covered hospitalization, was similar to fire insurance.  Most people would not go to the hospital in a given year, and therefore money would build up in the insurance pool which could be invested.  Modern health insurance, however, is really just prepaid healthcare.  Because it covers doctors visits, shots, and other things that most people do each year, most of the money that people pay into health insurance is paid out in claims each year.  Also, unlike homeowners insurance that most people do not use and would not use unless there was a major event, many people will go to the doctor for the least thing because they have the sense, correctly, that they are paying for it anyway.  Likewise, they might choose the expensive medicine over the cheap medicine because they like the color of the pill or the box it comes in.  If they had to pay $100 more themselves, they likely would not think the color or the box was worth the extra price.

So with health insurance, you are just paying the cost of your likely medical expenses each year to an insurance company, which then turns around and pays the doctors, in addition to paying into a risk pool for major events.  The portion going to the risk pool for the very serious conditions that require hospitalization may be building up and being invested, but the portion going to general healthcare like doctor’s visits is spent each year.  Because the money is being spent each year, the cost is equal to the amount you would pay the doctor when you went plus the cost of the insurance company administration, advertising, and a fee to make it worth their while.  So you end up paying more for healthcare than you would if everyone just went to the doctor and paid cash and only used insurance for hospitalization.

In addition, because the natural tendency is for people to use more healthcare since it costs the same whether they use it or not and because the most expensive treatment and the least expensive treatment generally cost the same to the patient, insurance costs are higher than they would be if people were limiting their visits and choosing the low-cost treatment because they were paying out of their own pockets.  This feeds on itself, with premiums increasing, causing people to be more likely to go to the doctor and “get their money’s worth.”  We would be paying less and be in a much better situation if health insurance were like auto insurance, where you pay for the tune-ups and the oil changes yourself, reserving the insurance for only unexpected accidents.

Contact me at, or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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