What is Insurance?

What is Insurance?


Insurance has always been a way for you to invest in protection against a catastrophic financial loss.

Here is how pure insurance is set up. Let’s say that you need a policy to protect you against the financial loss from breaking your arm. Let’s call this a broken arm policy. Let’s say now that you want this policy to replace lost income of $10,000.00.

Now the insurance company actuary has determined that broken arms occur twice in every 1000 people every year. (This is made up for the purposes of the example. Don’t quote me on the incidence of broken arms!) Now the actuary can accurately determine through his formulas how many people will break their arms out of 1000, he just doesn’t know who.

Now also through their research they determine that if the policy is priced at a level of $20.00 per year that 2000 people will buy the policy. So the insurance company issues 2000 policies at a cost of $20.00 per year. The total collected is $40,000.00. The insurance company is wagering profit on the fact that only two people will file claims for the $10,000.00 for a total in paid claims of $20,000.00. The other $20,000.00 is for operating costs and cost of sales, etc.

Now the cost of $1.66 per month per individual obviously made it worth the risk for 2000 people. The risk for the insurance company was determined through extensive research and after that research they also felt it worth the risk. In this situation the insurance company actuaries predicted the number of claims perfectly and everyone was happy.

BUT as you can see the business of insurance actuarial tables is truly an art. If the actuary underestimated by even one profit was gone. If he missed by two, the company lost money. So if the company decided that they were going to offer the policy again the next year and their claims totaled $30,000.00 they would have to adjust the premiums.

IMPORTANT POINT: Claims paid determine the premium of policies.

Insurance companies assume a lot of risk. That could be why some insurance companies go out of business ever year.

Let’s now shift gears for a second and talk about what is being sold as “health insurance” right now. Based on current claim data provided by Mutual of Omaha, most insurance claims (around 70%) are for procedures less than $2000.00. with about half of those claims totaling less than $250.00 each.

The point here is that health insurance has become less about protecting against catastrophic financial losses and more about the insurance paying for doctors visits. Now remember in the broken arm policy example the insurance company assumed risks based on their ability to make a profit. What is called “health insurance” now is no different. Your health insurance carrier must also make a profit or next year they will join the insurance companies that go out of business. So what happens is that you pay your health insurance company premiums approximately one and one half times the actual costs of total claims paid for your risk group.

The average person goes to the doctor two and one half times per year. Only 7% of people actually file a claim for costs exceeding $2000.00 for a single claim. That is for a hospital stay with the average hospital stay costing around $20,000.00.

Question 1: Does it make sense to pay your “health insurance” company almost $5000.00 a year to cover doctor visits when they cost less than $250.00 per visit?

Question 2: Would it make more sense to write policies that only covered the cost of hospital expenses?

If you have questions please contact me at healthdennis@gmail.com