How Health Insurance Works

With the new healthcare law in effect, many people are starting to look at healthcare plans.  Many people simply look at the amount they will be paying each month when choosing a plan.  People also tend to say they like their health insurance as long as the premiums are reasonable and they don’t actually have a major event such as a hospitalization.  There are a lot of other important factors to consider, however, and it can cost you a lot more than you think if something happens, even with insurance.  In the very least, you should have some cash saved and ready, even if you have insurance, just in case you end up in the hospital.  Today I thought I would cover some of the basics about health insurance and what you need to do to protect yourself in case of a medical event.

First of all, let me say that understanding the terms of an insurance plan can be very complicated – not because it actually is complicated, but because the insurance industry has created their own language.  I remember when I started work, listening to the HR department rattle off all sorts of terms that I didn’t understand.  It was only after using insurance for a period of time that I began to put things together.  To help others along so you don’t need to learn on your own, here are some common insurance terms to know:

Premium:  This is the amount that you must pay the insurance company, usually shown as a monthly or a bi-weekly amount (probably because the yearly amount would scare you).  If you don’t pay your premium, or possibly if you pay it late, you don’t have insurance.  Whether you use the insurance during the year or not, your premium money will be gone once you send in a check.

Part of the premium goes to the insurance company as profit, but most (like 95% or more) goes to pay claims for other people.  The insurance company doesn’t have a big pot of money from which they can withdraw to pay your claim.  They are collecting money each year and paying most of it out in claims, just keeping a little bit to pay for administrative functions and as profit.  Note also that with health insurance, most people have at least some claims each year, so a portion of what you pay is really prepaying for healthcare.  Note also that the more claims people are filing, the more the premiums will be the next year to cover the costs.  There is nothing “free” with insurance – you just pay for it with your premiums.

Deductible:  This is the amount you must pay before the insurance company starts paying anything.  For example, if you have a $5,000 deductible, you’ll need to pay for the first $5,000 worth of bills out of your pocket before the insurance company will pay a dime.  Some services, like office visits, may not have the deductible apply, so the insurance may pay for most of the cost of an office visit from the start.  But again, this is because you are really prepaying for these office visits with your premium.  The insurance company just figures out how often the average person will go to the doctor, what that will cost, and adds it to the premium.

CoPay:  This is an amount that you will need to pay that typically does not get counted toward your deductible.  For example, many plans have $20 copay for office visits, meaning that each time you see the doctor you pay $20.  Even after you have met the deductible, you will normally still be paying the copay each time you see the doctor.

Coinsurance:  Once the insurance plan actually does start paying, the amount they pay is usually dictated by the coinsurance rates.  As an example, if the coinsurance rate is 80-20, it would mean that the insurance would pay 80% of the bill and you would pay the other 20%.  Again, this is after you have paid enough to meet the deductible.

Out-of-Pocket Yearly Maximum:  This is the amount above which you will no longer be subject to the coinsurance payment.  The insurance company from that point forward in the same year will pay the whole bill.  Again, you would usually still be paying copays when you see the doctor.  This just covers the costs from other services.

In-Network Provider:  An in-network provider is a doctor with whom the insurance company has negotiated a special rate.  When you receive the monthly claim details back from the insurance company (called an EOB or “Explanation of Benefits,”) it will show the bill from the doctor reduced due to these pre-negotiated rates.  The doctor could just have sent a bill for the correct amount to the insurance company, but the doctors rarely know what they have negotiated, so they often send some rate that will be high enough to be more than the insurance company will pay.  Perhaps the insurance companies could stop this practice, but this way it looks like the insurance company is saving you a lot of money, so maybe this is done for effect to make you think your insurance is giving you big savings.

Out-Of-Network Provider:  A doctor with which they do not have an agreement.  If you go to one of these, not only will you owe more because the rate will be higher (and therefore your 20% will be higher), but the insurance company will typically require a higher coinsurance amount.  For example, they may pay 80% of an in-network provider bill, but only pay 50% of an out-of-network provider’s bill, leaving you with the rest.

Now that the jargon has been explained, let’s look at an example.  In the healthcare exchange, the monthly premium for a fairly health individual without a subsidy might be around $600 for a “bronze” plan.  The deductible for these plans is fairly high, typically about $4000 per year for a family plan.  The coinsurance for a bronze plan is 60-40, meaning the consumer would be responsible for 40% of the bill for an in-network provider.  the out-of-pocket max for these plans is $12,500 for a family plan, meaning that the most you would pay for the year out-of-pocket is $12,500.

This means that the consumer would spend $600 x 12 months = $7200 in premiums each year whether they went to the doctor or not.  Visits to the doctor for preventative care would then largely be covered, so for example one could then go for a yearly physical without an additional charge (probably not even a copay).  Visits to an in-network doctor would be subject to a copay – typically $20 for a primary care doctor or $40 for a specialist, so this would be the cost of an office visit.

If you had a condition that required treatment, this would be subject to the deductible and then the coinsurance.  For example, if you got a bad case of the flu and went to the hospital for a week, you might have a $30,000 hospital bill.  If the hospital is in-network, this might get knocked down to $12,000 due to the negotiated rates.  At that point, you would pay the first $4,000 of the bill because of the deductible.  The insurance would then start to pay 60%, so of the next $8,000, you would pay $3200 and the insurance would pay $4800.  So, you would have paid a total of $14,400 for the hospital stay, including $7200 in premiums, $4000 for the deductible, and $3200 for coinsurance.

If you wanted to reduce your copay a bit, you could opt for a higher tier insurance plan.  For example, if you got the gold plan, the coinsurance is 80-20.  In this case you would only pay the $4000 deductible plus $2400 of the remaining bill, or $800 less than with the bronze plan.  The premium would be higher, however, so you might pay $1000 per month for the gold plan.  Your total cost for the hospital stay would then be $12,000 in premiums, $4000 for the deductible, and $2400 in coinsurance, for a total of $16,400.  Not exactly a great deal when compared to the bronze plan in this case.  Even though you pay less for the hospital stay, because your premium is so much higher, you end up paying more in total.

Probably the take-away from this analysis is that just because you have a health insurance plan doesn’t mean you don’t need to have some money saved up for doctor and hospital bills.  Because the deductibles and copays on the new ACA insurance plans are so high, you still need to have a large amount of savings in case there is a hospitalization.  To estimate how much you need to have saved, perhaps take the deductible and then double it since that would be enough to cover a fairly significant event.  To be fully safe, you’d need to have the full out-of-pocket maximum saved and ready ($12,500 for a family plan).  Note that this would need to be in cash, so you’ll be losing money to inflation each year, even if nothing happens.

Editorial note – Surely there’s a better way.

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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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