Monday, September 14, 2009


The beautiful nation of Rowhousia has a meteorite problem. Random and unpredictable meteors fall on the nation, destroying one out of every one thousand homes every year. All the citizens of Rowhousia live in identical houses, each costing one hundred thousand dollars. Because the houses are the same size, each house is equally likely to be hit by a meteor, and the strikes are devastating, requiring that the house be completely replaced at full cost.

Insurance companies have sprung up to protect people from the risk of meteor strikes. The actuaries at these insurance companies have the job of computing the cost of the insurance based on the risk and the cost of a meteor strike. It's not a bad gig if you can get it. The equation for the expected payout is simply the probability of a strike times the cost of a strike. In this case 1/1000 * $100,000 = $100. Add a small margin of error, the administrative and overhead costs, and a profit margin, and you get the price of a meteor policy. Companies charge around $120 per year of coverage. Most Rowhousians consider this to be a prudent purchase, and buy a policy. Some decide to take the risk and go uninsured.

One particular company insures a million Rowhousians. In the typical year they collect $120 million in premiums. One thousand of the houses they protect are destroyed during the year, and the company pays out $100 million to repair those houses. That leaves $20 million, some of which goes to pay their employees salaries, the rent for their office building, postage for their statements, and to cover other expenses. Whatever is left is profit for the investors who provided the capital to create the company.

The citizens of Rowhousia fall into four categories:

Some bought insurance and didn't need to collect on it. They were fortunate that their house was not hit this year. They are out $120, but that's a small price to pay for the security of being protected. They are aware that most of their premiums went to replace the houses of other less fortunate Rowhousians, and they are also aware that next year they might be the one who needs the coverage. They have no problem with the situation because they voluntarily decided to participate in the system, having considered the options and decided that it was in their best interest.

Others are very glad that they bought insurance, because it paid for the replacement of their house when it was destroyed by a meteor strike. They would have preferred to not deal with all the trouble of replacing their house, but they are much better off than they would have been without the insurance.

A third group decided to play the odds and got by with it this year. They didn't buy insurance, and their house was not destroyed. They are a little bit ahead of those in the first group, because they still have their $120, but they are living on the edge. Some of them are wealthy enough that replacing their house would not be a problem. Those people may be making a reasonable decision, because the odds of never being hit by a meteor are in their favor, and the overhead costs of insurance make it a losing prospect in the long term. Others don't have enough money to replace their house, and didn't buy insurance because they have other needs they see as more pressing. They are in serious danger because if their house is destroyed they won't have the means to obtain shelter.

A forth group didn't buy insurance and lost their house. These people are the big losers, particularly those who are living paycheck to paycheck. One year the unfortunate members of this forth group decide that they want to buy meteor insurance retroactively, so that the insurance companies will have to pay for the damage which has already been done to their houses. They take their $120 and go to the insurance company, expecting to trade their $120 check and insurance policy application for a $100,000 settlement check. The insurance company representative explains to them that you must buy a policy on an intact house before the house is destroyed. They won't insure a house with a pre-existing meteor strike.

The irate Rowhousians form a grassroots political organization, petitioning the government of Rowhousia to address this grievous injustice. They march, chant, and carry signs demanding "Meteor Insurance Now!" Soon a leader emerged to champion this group. He had never actually had a productive job before, but he could speak in such soothing tones that all who heard him were lulled into a trance, obeying his every utterance. He was known only as Obummah.

Under the leadership of Obummah, the government of Rowhousia passed a new law requiring that meteorite insurance companies sell insurance to anyone, even those with a pre-existing meteor strike. Joy and harmony filled the land.

Uninsured Rowhousians whose house had been demolished hurried to purchase their insurance and claim their settlement. Meanwhile, Rowhousians who had purchased insurance year after year without ever needing to make a claim began to wonder how this was fair. Why should they buy insurance before their house is struck, knowing that in all likelihood they won't need to collect on it? Isn't it much smarter to save your money and only buy insurance if you actually need it?

When it came time to renew their insurance, nobody did. The only people buying insurance were those whose house was already reduced to a pile of smoldering debris. The actuaries recomputed the price for insurance using the same formula: expected payout equals the probability of a strike times the cost of a strike. Only now the probability is not one in one thousand. Every house they insure needs to be replaced. The cost of insurance is 1/1 * $100,000, or $100,000. Add to that the administrative costs, overhead, and profit margin and insurance isn't a good deal, even for those with a pre-existing condition.

Medical insurance is far more complicated than this simple example, but the same principles apply. When you buy medical insurance, you are paying the insurance company to assume the risk that you will need expensive treatment. The calculations that actuaries use to price medical insurance are vastly complicated, taking into account many different risk factors unique to each policy holder. Ultimately it comes down to a summation of the expected costs of a long list of covered conditions. The formula for expected cost is the same as it was in Rowhousia: the probability of a condition occurring times the cost of treating it. The cost of treating a certain form of cancer may be very high, but if only one in ten thousand policy holders get that kind of cancer, the cost is spread broadly and the insurance remains affordable. But if a new customer applies for coverage and already has that kind of cancer, the company is not being asked to assume a risk of one in ten thousand. They are being asked to fund what is certain to be a hugely expensive treatment. The proper pricing for that insurance is more than the cost of the treatment.

For insurance to work, if must be purchased when it still represents a risk, not a certainty. That is why requiring insurance companies to cover pre-existing conditions can't work. It undermines the principles of sharing risk which permit insurance to protect their policyholders.


Garrett said...

I have to be honest that this was the worst analogy I have ever read. Trying to relate insurance fraud to medical pre-existing conditions is a stretch only the dense would accept. You can do MUCH better... Next time actually think through your analogies and stop making this argument look like a child's logic.

Don Dodson said...

There was no fraud involved. They didn't represent their house as being intact. The analogy is exact because in both cases there is no risk. There is the certainty of a large expense.

Do you think that it is fair that insurance companies should have to approve a new policy for someone who is certain to cost many times more than the cost of the policy?

Garrett said...


I apologize my comments were a little harsh. And no I don't think that is necessarily a fair business practice. The problem with the analogy though is that many persons are unaware that they are going to become seriously ill, and the pre-existing conditions which the insurance companies many times use to reject or drop customers are completely unrelated to their costly illness. Sometimes... yes the customers do seek to get an unfair advantage, but I have heard and imagine there are just as many occasions where the insurance companies have used the legal loophole of "pre-existing conditions" to drop those they will not profit from.

I would liken it to your axle breaking and the warranty refusing to pay because you had a loose fan belt. I think the "right" amount of reform would keep insurance companies from being able to use legal loopholes in cases where the pre-existing conditions cannot be directly related back to the condition suffered.

So for example... If you have a chronic history of pneumonia due to smoking and then get a policy and try to claim problems with bronchitis without reporting the smoking and pneumonia... then there are some avenues for that person to answer to a non-disclosure of such. But failing to report smoking and being diagnosed with MS... I don't think there would be much evidence to relate those two together.

It's not necessarily a fault of "bad" insurance people... I think its just that because they are focused on profits... they run them like a business. I don't necessarily think that profit driven businesses do the best job when the "right" moral decisions sometimes mean taking the company into the red for a year or two.

This comment was fairly quickly written so I apologize about it not being more polished. I liked your most recent post about the reflections you have had in the back and forth very much. And agree with pretty much your entire newest post!

Don Dodson said...

Garrett, the concept of a "material factor" is the important criteria. A material pre-existing condition is a valid reason to reject an application for a new policy. A non-material condition is not a valid reason. Material fraud in an insurance application is reason to cancel a policy. A non-material error is not. There need to be established standards regarding what is material, and probably some kind of independent arbitration system to resolve disputes.