Cost of Health Insurance

Posted by PITHOCRATES - May 27th, 2013

Economics 101

Making Health Insurance a Fringe Benefit removed Market Forces from the Equation

The reason why health insurance is so expensive is because it is not insurance anymore.  It’s more of a welfare program.  Where other people pay.  Whereas insurance mitigates financial risk.  People pay a small premium to insure against a large financial loss.  They may pay $250/year to insure something that may cost $25,000 to replace.  For something they may own for 10 years.  Because they would rather spend $250 each year (for a total of $2,500 over those 10 years) than have to replace it by paying another $25,000 should something happen.  Insurance reduces the amount of money you can lose.  In this case the greatest financial loss is reduced from $25,000 down to $2,500.  This is insurance.

Health insurance used to be like this.  When we paid for it ourselves.  But things changed when it became an employee benefit.  Where we no longer saw the true cost of that insurance.  This happened during World War II.  As FDR put in wage caps.  Why?  With all the men in the military and wartime production through the roof there was a shortage of labor.  And the last thing FDR wanted on top of the inflation they were causing by printing so much money to pay for the war was wage inflation.  Hence the wage caps.  But the problem with wage caps is that employers could not entice the best workers to come work for them by offering them higher wages.  So to entice the best workers to come work for them and get around FDR’s wage caps employers began offering fringe benefits.

This is the cause of all our health care woes today.  Making health insurance a fringe benefit.  For it removed market forces from the equation.  People receiving the benefit had no idea what the benefit cost.  And did not care.  Which wasn’t a problem at first.  But then the Sixties came around.  And women stopped having as many babies.  Causing the population to start getting older.  Worse (from the perspective of paying for health insurance), people were beginning to live longer.  So when a person retired from a company they lived a long retirement.  So companies who offered these generous fringe benefits began to suffer under the cost of them.  Between pensions and health care costs retirees were costing some companies more than their active workers.  Because they were living so long into retirement.  (Just as these long retirements are straining Social Security and Medicare).  And modern medicine just keeps pulling them back from the brink of death.  Prolonging this crushing financial burden.

Health Insurance is more Expensive than it once was because it now Pays for Routine Medical Expenses

Compounding this problem is how health insurance is no longer insurance.  Instead of a small premium insuring against a large financial loss people expect health insurance to pay for everything.  And get righteously indignant whenever they have to pay anything out of pocket.  From a prescription co-pay.  To a small co-pay at a doctor’s office.  This is not paying a small premium to insure against a large financial loss.  This is demanding a free ride.  If health insurance was actually insurance it would look something like this:

Health Insurance Cost - Insurance

This assumes a health group with 100 participants.  Of this 100 five people suffer a serious accident in one year.  Incurring a large and unexpected hospital expense of $6,000 each.  While three people suffer a serious illness that same year.  Incurring a large and unexpected hospital expense of $4,500 each.  The total for these large and unexpected costs is $43,500.  If we divide this over the 100 members of the group that comes to an annual health insurance premium of $435 each.  Or $36.25/month.  Or $8.37/week.  Which isn’t much.  If you were one of those suffering a serious accident you didn’t have your personal finances wiped out by an unexpected $6,000 hospital bill.  Instead you only paid a manageable and budgeted $435 each year.  In other words, spending $435 saved $5,565.  Not a bad deal.  This is insurance.  Because it only paid for the unexpected.  Not our routine health care expenses that we should pay out of pocket.  If we add these routine expenses into the health insurance formula we can see how they increase the cost of health insurance.

Health Insurance Cost - Welfare

Assume each person consume $750 in routine medical costs.  For office visits.  Allergy shots.  Vaccinations for the children.  Flu shots.  Seeing the doctor when you have a cold.  Annual checkups.  Physicals.  Cancer screening.  Prescriptions.  Etc.  Those things that can be reasonably expected each year.  When our health insurance policies pay for these routine medical expenses note the large increase in the annual insurance policy premium.  Going from $435 to $1,185.  An increase of 172%.  Everyone will pay $1,185.  Whether they consume $750 in medical costs or not.  Also, of the three things health insurance pays for (serious accidents, serious illnesses and routine medical) routine medical is the biggest of the three.  Explaining why health insurance is now so much more expensive than it needs to be.

It was the Pension and Health care Costs of Retirees that Bankrupted General Motors

This is why it is better to pay out of pocket for these routine costs.  Because if you’re really healthy one year and never see the doctor you will not consume $750 in medical costs.  So if you normally pay these out of pocket but don’t you would only spend $435 that year for real health insurance.  Not the $1,185 that pays for everything.  Whether you use it or not.  This is where market forces come in.  Instead of paying for a costly doctor’s visit when you have a cold you may just buy some over the counter cold medicine from the drugstore.  This is how we behave when we pay for stuff.  But when you introduce a third party it alters our behavior.

“Whether you use it or not.”  When people can get something more for no extra money they are going to take it.  Like going for seconds and thirds at an all-you-can-eat buffet.  It doesn’t cost anything more for the second and third plate.  In fact people will feel cheated if they don’t go for plates 2 and 3.  Because all-you-can-it is pretty expensive if you only eat one plate.  Because that one price pays for 2, 3, even 4 plates.  If you can eat that much.  It’s this mentality that causes people to go to the doctor when they have the sniffles.  So they can get ‘free’ antibiotics.  Because it doesn’t cost anything more.  Since their health insurance is already paying for it.

But it does cost more to those who are paying for it.  A lot more.  So much more that small business owners can’t afford to provide health insurance for their employees.  Because to do so would require that they greatly increase their selling price.  Which they can’t do and expect to stay in business.  Because the market sets the price.  Not them.  It’s up to them to figure out how to sell at a price the people will pay.  And if they raise it too high to pay for health insurance for their employees the people will stop buying from them.  Putting them out of business.  Even bigger businesses struggle with this.  For it was the pension and health care costs of retirees that bankrupted General Motors.  Which was one of those companies that started offering health insurance as a benefit during World War II.  Giving us all our health care woes today.

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Britain trying to Spread the Risk and Cost of Floods to those who Don’t Live in Floodplains

Posted by PITHOCRATES - December 9th, 2012

Week in Review

Insurance manages financial risk.  One of the earliest forms of insurance was marine insurance.  For it was very risky shipping things across the ocean.  Sometimes storms damaged ships.  Requiring the crew to jettison some cargo to make the damaged ship seaworthy.  So all shippers paid a little extra to provide something we called ‘general average’.  So when the ship reached its destination those who still had cargo aboard could sell it.  While those whose cargo went overboard to make the ship safe for everyone else got this insurance money.

Those who were taking a risk bought insurance to manage their risk.  So that in the event of a loss they mitigated their financial losses.  This is a very important fundamental of insurance.  Those who take a risk pay the costs of managing that risk.  A blacksmith working in an inland community didn’t contribute to the general average.  Because he had no risk exposure on that ship.  So to reiterate, risk takers pay the cost of insurance to mitigate their potential financial losses.  Which the free market does brilliantly.  Except when an activity is so risky that everyone exposed to a risk will suffer a loss.  As in flood insurance (see Flood insurance warning by MP Jonathan Evans posted 12/9/2012 on BBC News Wales).

The existing deal, reached in 2008, obliges insurers to provide cover for high-risk properties while the UK government continues to fund improved flood defences…

The Association of British Insurers (ABI) is calling on the government to share the financial risk for the areas with the most homes at significant flood risk…

“The reason for that is that people who are at risk of flood, lots of those people being in Wales, a quarter of a million houses across the UK, those people are probably paying about a half of what the real risk of flood is,” he said…

“No country in the world has a free market for flood insurance with high levels of affordable cover without some form of government involvement.”

“We could have a complex system in which we could potentially see a charge of £20 or £30 across the board for everybody – whether affected by flood or not – with everybody doing their bit.

“But that could be viewed as being unfair on the poor.”

The problem with flood insurance is that everyone engaging in risky behavior by living in a floodplain will suffer a loss.  If a flood washes away every home they will have to rebuild every home.  Instead of everyone paying a little bit to pay for one or two lost homes everyone will have to pay a lot.  To cover the replacement value of their own home.  Because there is no way to spread the risk when everyone suffers a loss.

When your insurance premium is the value of the home your insurance is not insurance.  You’re just putting some money aside so you can buy your house again in another 10 years or so.  Or however often a floodplain floods.  Which is the risk people take by living in floodplains.  Or should be.  But governments step in and have the responsible living outside of floodplains subsidize the risky behavior of those living in floodplains.  By subsidizing the cost of their irresponsible behavior with taxpayer money.

Yes, it is heart-wrenching to see the devastation of a massive flood.  Like in New Jersey and New York following Hurricane Sandy.  And seeing those homeowners lose everything.  Especially those who did not renew their federally provided flood insurance (it is a federal requirement to buy flood insurance when buying a house in a floodplain.  But there is no federal requirement to renew that coverage once the initial term of that policy expires).  Because it was too costly.

Coastal areas have beautiful vistas.  Which is why people take risks and move into floodplains.  But if they do they should bear the financial costs.  Not those living responsibly.  With far less beautiful vistas.

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LESSONS LEARNED #24: “You cannot lobby a politician unless he or she is for sale.” -Old Pithy

Posted by PITHOCRATES - July 29th, 2010

BUILDING A RAILROAD ain’t cheap.  It needs dump trucks of money.  Especially if it’s transcontinental.  And that’s what the Union Pacific and the Central Pacific were building.  Starting during the Civil War in 1863 (the year Vicksburg fell and Lee retreated from Gettysburg).  The Union Pacific was building west from Iowa.  And the Central pacific was building east from California. 

For the most part, Protestant, English-speaking Americans settled Texas.  Mexico had encouraged the American colonists to settle this region.  Because few Mexicans were moving north to do so.   The deal was that the colonists conduct official business in Spanish and convert to Catholicism.  They didn’t.  These and other issues soured relations between Mexico and the American Texans.  The Republic of Texas proclaimed their independence from Mexico.  America annexed Texas.  Mexico tried to get it back.  The Mexican-American War followed.  America won.  Texas became a state in 1845.  And that other Spanish/Mexican territory that America was especially interested in, California, became a state in 1850.  Hence the desire for a transcontinental railroad.

The U.S. government was very eager to connect the new state of California to the rest of America.  So they acted aggressively.  They would provide the dump trucks of money.  As America expanded, the U.S. government became the owner of more and more public land.  The sale of new lands provided a large amount of revenue for the federal government.  (Other forms of taxation (income taxes, excise taxes, etc.) grew as the amount of public lands to sell decreased.)  Land is valuable.  So they would grant the railroad companies some 44 million acres of land (i.e., land grants) for their use.  The railroad companies, then, would sell the land to raise the capital to build their railroads.  The government also provided some $60 million in federal loans.

But it didn’t end there.  The federal government came up with incentives to speed things up.  They based the amount of loans upon the miles of track laid.  The more difficult the ground, the more cash.  So, what you got from these incentives was the wrong incentive.  To lay as much track as possible on the most difficult ground they could find.  And then there were mineral rights.  The railroad would own the property they built on.  And any minerals located underneath.  So the tracks wandered and meandered to maximize these benefits.  And speed was key.  Not longevity.  Wherever possible they used wood instead of masonry.  The used the cheapest iron for track.  They even laid track on ice.   (They had to rebuild large chunks of the line before any trains would roll.)  And when the Union Pacific and Central Pacific met, they kept building, parallel to each other.  To lay more miles of track.  And get more cash from the government.

PAR FOR THE COURSE.  When government gets involved they can really mess things up.  But it gets worse.  Not only was government throwing dump trucks of American money down the toilet, they were also profiting from this hemorrhaging of public money.  As shareholders in Crédit Mobilier.

Thomas Durant of Union Pacific concocted the Crédit Mobilier Scandal.  As part of the government requirements to build the transcontinental railroad, Union Pacific had to sell stock at $100 per share.  Problem was, few believed the railroad could be built.  So there were few takers to buy the stock at $100 per share.  So he created Crédit Mobilier to buy that stock.  Once they did, they then resold the stock on the open market at prevailing market prices.  Which were well below $100 per share.  Union Pacific met the government requirements thanks to the willingness of Crédit Mobilier to buy their stock.  The only thing was, both companies had the same stockholders.  Crédit Mobilier was a sham company.  Union Pacific WAS Crédit Mobilier.  And it gets worse.

Union Pacific chose Crédit Mobilier to build their railroad.  Crédit Mobilier submitted highly inflated bills to Union Pacific who promptly paid them.  They then submitted the bills to the federal government (plus a small administration fee) for reimbursement.  Which the federal government promptly paid.  Crédit Mobilier proved to be highly profitable.  This pleased their shareholders.  Which included members of Congress who approved the overbillings as wells as additional funding for cost overruns.  No doubt Union Pacific/Crédit Mobilier had very good friends in Washington.  Including members of the Grant administration.  Until the party ended.  The press exposed the scandal during the 1872 presidential campaign.  Outraged, the federal government conducted an investigation.  But when you investigate yourself for wrongdoing you can guess the outcome.  Oh, there were some slaps on the wrists, but government came out relatively unscathed.  But the public money was gone.  As is usually the case with political graft.  Politicians get rich while the public pays the bill.

(Incidentally, the investigation did not implicate Ulysses Grant.  However, because members of his administration were implicated, this scandal tarnished his presidency.  Grant, though, was not corrupt.  He was a great general.  But not a shrewd politician.  Where there was a code of honor in the military, he found no such code in politics.  Friends used his political naivety for personal profit.  If you read Grant’s personal memoirs you can get a sense of Grant’s character.  Many consider his memoirs among the finest ever written.  He was honest and humble.  A man of integrity.  An expert horseman, he was reduced to riding in a horse and buggy in his later years.  Once, while president, he was stopped for speeding through the streets of Washington.  When the young policeman saw who he had pulled over, he apologized profusely to the president and let him go.  Grant told the young man to write him the ticket.  Because it was his job.  And the right thing to do.  For no man, even the president, was above the law.)

THE FINANCIAL WORLD fell apart in 2007.  And this happened because someone changed the definition of the American Dream from individual liberty to owning a house.  Even if you couldn’t afford to buy one.  Even if you couldn’t qualify for a mortgage.  Even, if you should get a mortgage, you had no chance in hell of making your payments.

Home ownership would be the key to American prosperity.  Per the American government.  Build homes and grow the economy.   That was the official mantra.  So Washington designed American policy accordingly.  Lenders came up with clever financing schemes to put ever more people into new homes.  And they were clever.  But left out were the poorest of the poor.  Even a small down payment on the most modest of homes was out of their range.  Proponents of these poor said this was discriminatory.  Many of the inner city poor in the biggest of cities were minority.  People cried racism in mortgage lending.  Government heard.  They pressured lenders to lend to these poor people.  Or else.  Lenders were reluctant.  With no money for down payments and questionable employment to service these mortgages, they saw great financial risk.  So the government said not to worry.  We’ll take that risk.  Fannie Mae and Freddie Mac would guarantee certain ‘risky’ loans as long as they met minimum criteria.  And they would also buy risky mortgages and get them off their books.  Well, with no risk, the lenders would lend to anyone.  They made NINJA loans (loans to people with No Income, No Job, and no Assets).  And why not?  If any loan was likely to default it was a NINJA loan.  But if Freddie or Fannie bought before the default, what did a lender care?  And even they defaulted before, Fannie and Freddie guaranteed the loan.  How could a lender lose?

Once upon a time, there was no safer loan than a home mortgage.  Why?  Because it would take someone’s lifesavings to pay for the down payment (20% of the home price in the common conventional mortgage).  And people lived in these houses.  In other words, these new home owners had a vested interested to service those mortgages.  Someone who doesn’t put up that 20% down payment with their own money, though, has less incentive to service that mortgage.  They can walk away with little financial loss.

ARE YOU GETTING the picture?  With this easy lending there was a housing boom.  Then a bubble.  With such easy money, housing demand went up.  As did prices.  So housing values soared.  Some poor people were buying these homes with creative financing (used to make the unqualified qualify for a mortgage).  We call these subprime mortgages.  They include Adjustable Rate Mortgages (ARMs).  These have adjustable interest rates.  This removes the risk of inflation.  So they have lower interest rates than fixed-rate mortgages.  If there is inflation (and interest rates go up), they adjust the interest rate on the mortgage up.  Other clever financing included interest only mortgages.  These include a balloon payment at the end of a set term of the full principal.  These and other clever instruments put people into houses who could only afford the smallest of monthly payments.  The idea was that they would refinance after an ‘introductory’ period.  And it would work as long as interest rates did not go up.  But they went up.  And house prices fell.  The bubble burst.  Mortgages went underwater (people owed more than the houses were worth).  Some people struggled to make their payments and simply couldn’t.  Others with little of their own money invested simply walked away.  The subprime industry imploded.  So what happened, then, to all those subprime mortgages?

Fannie and Freddie bought these risky mortgages.  And securitized them.  They chopped and diced them and created investment devices called Collateralized Debt Obligations (CDOs).  These are fancy bonds backed by those ‘safe’ home mortgages.  Especially safe with those Fannie and Freddie guarantees.  They were as safe as government bonds but more profitable.  As long as people kept making their mortgage payments.

But risk is a funny thing.  You can manage it.  But you can’t get rid of it.  Interest rates went up.  The ARMs reset their interest rates.  People defaulted.  The value of the subprime mortgages that backed those CDOs collapsed, making the value of the CDOs collapse.  And everyone who bought those CDOs took a hit.  Investors around the globe shared those losses. 

Those subprime loans were very risky.  Lenders would not make the loans unless someone else took that risk.  The government took that risk in the guise of Fannie and Freddie.  Who passed on that risk to the investors buying what they thought were safe investments.  Who saw large chunks of their investment portfolios go ‘puff’ into thin air.

SO WHAT ARE Freddie and Fannie exactly?  They are government-sponsored enterprises (GSEs).  They key word here is government.  Once again, you put huge piles of money and government together and the results are predictable.  In an effort to extend the ‘American Dream’ to as many Americans as possible, the federal oversight body for Freddie and Fannie lowered the minimum criteria for making those risky loans.  Even excluding an applicant’s credit worthiness from the application process (so called ‘no-doc’ loans were loans made without any documentation to prove the credit worthiness of the applicant.)  To encourage further reckless lending.  Ultimately causing the worst financial crisis since the Great Depression. 

And, of course, members of Congress did well during the good times of the subprime boom.  They got large campaign contributions.  Some sweetheart mortgagee deals.  A grateful voting bloc.  And other largess from the profitable subprime industry.  Government did well.  Just as they did during the Crédit Mobilier Scandal.  And the American taxpayer gets to pay the bill.  Some things never change.  Government created both of these scandals.  As government is wont to do whenever around huge piles of money.  For when it comes to stealing from the government, someone in the government has to let it happen.  For it takes a nod and a wink from someone in power to let such massive fraud to take place. 

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