Insurance, How does it work?

Factual Questions
1

As I understand it, a person/corporation takes out insurance to protect it from what may happen. This entails the person/corporation paying a premium every year (according to the contract) and if something goes wrong then the insurance agency will pay for it (according to contract).

Why then are insurance companies (in Australia) collapsing and our medical system is about to grind to a halt because of insurance problems. Our largest insurer and reinsurer (HIH) collapsed last year, causing all sorts of problems. Since then other insurance companies have pulled out of the Australian market and UMP – the leading medical insurer – has indicated that it is having real problems (leading to calls today that all doctors are going to go on strike until the government does something).

Basically what I want to know is why is this happening? Insurance companies are charging an awful lot of money, yet they are falling over.

There has been a lot of stuff in the papers and so on, but can someone explain it in simple non-financial terms for me? I have skipped over a lot of stuff, and I have follow up questions, but they are mainly ethical, such as if a corporation hasn’t made an insurance claim for 20 years, why would their insurance premium rise 300% in one year? Aren’t they assessed on an individual basis?

Thanks for you time,
FloChi, who has not had experience with insurance, but probably soon will.

2

Insurance companies don’t do it on a case-by-case basis, rather they plug your statistics into a giant database of probabilities and offer you a premium based on that. If you are insuring a company that is very similar to a company that cost them a lot of money in the past, chances are you’re going to be paying more money because the insurance company considers you to be more of a risk based on their past history.

One of my best friends programs COBOL for The Hartford and is responsible for updating and maintaining those huge databases. He tells me all sorts of stories about them; the company might have 20 different rates to insure a Honda Accord based on everything from the color of the car to the prior driving record of the owner. They’re basically gambling that you won’t cost more then you pay and so they make sure to be on top of the statistics .

3

One reason that insurance premiums have gone up recently is that this country has been getting more litigious :frowning: and the amount of damages paid to people who sue has gone up.

So in your hypothetical case of a company that hasn’t had a claim in twenty years, the chances that they will make a claim hasn’t gone up, BUT the likely amount that any claim will cost, has.
As far as insurance companies going bust is concerned - Basically when an insurance company is figuring out its premiums, it has to make a guess about how much money it will, on average, have to pay out to ALL the companies it covers. If it guesses badly, or if anything changes so it ends up paying MORE money than it thought, it’s toast.

4

The collapse of HIH made a big impact here in Hong Kong.

Insurers pool risk. Every policy holder pays what they would pay on average (among themselves) if something went wrong. That’s why statisticians, actuaries, and other people who are so fascinating to meet at parties are involved. The insurance company makes money by investing this pool of cash while waiting for the accidents.

The whole thing gets screwed up when juries or politicians tilt things too far in favor of the claimants - because everyone else loses (though in the popular imagination the evil insurance company is the only one to lose). Of course, the insurer passes the costs on to everyone else, or they go bust.

At the end of the day, you can’t get out any more out of it than other people put in.

5

How insurance works is described most easily for life insurance. The ideas are very similar for health insurance, but much more complicated to calculate or explain.

So, pretend that we’re an insurance company, and we have 1000 policy-holders, all age 35, each with a $100,000 policy. We look up on a table and find that the probability of a person age 35 dying before they reach age 36 is 1/1000.

So, we expect that our group of 1000 people age 35 will experience one death this year (one “claim”), and we’ll have to pay out $100,000 to the beneficiary. If we collect $100 per person as premium, we’ll have collected $100,000 and we’ll have just enough to pay the $100,000 claim.

So, we’re going to charge each person $100 in premium for the year. OK, we have to charge a bit more to cover our expenses, profit, administration, etc., but let’s ignore that for our example.

The problem is that we’re working on probabilities. We could have bad luck, and have two or three deaths from our group of 1000 people age 35. In that case, we would have to pay off $200,000 or $300,000 and we have NOT have collected enough premium, and we’d be in big trouble.

There are things we can do to protect ourselves, such as charging more – but if we charge $200 per person, or $300, we protect ourselves against adverse claims but may no longer be competitive, and we’ll lose business to the competition. We can also, as Hemlock says, insure ourselves – find another insurer who will take on the risk of us having more than one claim. That will cost us, and so will raise our premium, but would be a good protective device.

Life insurance is fairly predictable for very large groups (it’s just a probability experiment.) Thus, the arrangement I’ve described is usually fairly successful.

When it comes to health insurance, however, the situation gets much more complicated. Life insurance statistics are pretty simple – people either live or die, there’s not a lot of quibbling. A claim means someone died and gets paid the fixed amount.

With health insurance, we have a wide range of claims, from small amounts like for a doctor’s visit, to very large amounts, like for heart transplants. For some of these, we can look at past statistics of the number of occurrences, but there can be a lot of variation. For instance, there’s new technology, which is available faster than the statistics about its use. There are subjective factors – an article about X treatment in a local newspaper usually means a lot of people suddenly ask for X treatment. There are other subjective factors – state of health or how someone feels is not objectively measured.

So, if there have been years and years of claims exceeding premiums, the insurance company is in major financial trouble… even if they’ve been charging a lot in premiums.

That explanation help?

6

The only thing I’d like to add is that often premiums are just as low as Dex suggests–barely enough to cover expected payouts. This is because the insurer will invest the premiums it has collected while it is waiting to make pay-outs on claims (the lag period between when a policy is written, when an incident occurs, when a claim is filed and when a claim is paid is often significant and varies a lot based on the type of coverage–workers’ comp claims are “short-tail”–usually made within 2-3 years of coverage–while the total number of claims to be paid on medical malpractice and life insurance are often determined only after many years, “long-tail”). An insurer’s profits will usually depend on its investment return. Insurers were insulated from many bad guesses by the bull market of the 1990s; since that’s evaporated, many underlying problems are now being exposed.

7

Following up on what Humble Servant said, and with the disclaimer that I am a plaintiff’s trial lawyer, there are a lot of reasons other than lawsuits, etc., as Hemlock suggested. Insurance companies pay plenty-good bonuses to their executives. They sometimes get into price wars where premiums are cut to the nub in the hope that the other guy goes bust and their market share can be taken. If no one chickens out, sometimes all of the insurers go down together. In Texas right now, docs are going crazy over rising medical malpractice premiums. Of course, it’s all blamed on lawyers, plaintiffs, and juries. Little-reported is that one of the companies that had to pull out of the market had lost $100,000,000 plus on Enron last year, trying to make a few extra bucks by betting on a risky stock.

Of course, the legal system can and does play a role in things, but 99 times out of 100 it is just one factor in a very complicated calculus.

Not meaning for this to get into a GD,

JohnW77707, Esq.
Sticking it to the Man since 1993.

8

Following up on the preceding follow-up, the larger and better-run insurance companies do not pay claims out of premiums; all premiums are invested, and claims are paid out of earnings. Only in a very bad year (or during a dramatic shift in the actuarial assumptions that insurance is based on) will such a company touch its capital.

Thus the comment from an insurance agent on California’s Prop. 103, an insurance reform bill that became law:

“If this passes, we’re going to have to use premiums to pay claims!”

9

Whoops…my BS meter just pegged itself to extreme.

Certainly many factors makeup the overall cost of insurance. However, litigation is a HUGE portion of those costs and not just one part out of a hundred.

In Las Vegas malpractice insurance premiums for obstetricians and gynecologists just jumped 300-500%. It has gotten such that doctors are literally closing shop or outright refusing to take on patients because they simply can’t afford it.

“But,” a plaintiff attorney might say, “we are looking out for the little guy and keeping them from being taken advantage of when a rich doctor or hospital screws-up.” Certainly where there is legitimate negligence it is appropriate to put the screws to the person(s) who messed up. However, the vast majority of these cases are brought by ambulance chasers and win or lose they ratchet up the costs of doing business.

So, only 115 cases out of 1,064 filed seemed to have real merit and of the 949 that didn’t have merit 45% still went to trial.

It may be argued that my example doesn’t really bear on the issue in the OP because this is malpractice insurance and not health insurance. However, those added costs must get absorbed somewhere. A doctor in Las Vegas today will have to drastically raise his/her rates or go out of business. If they raise their rates those costs will be passed to the patients who will attempt to pass those costs to their health insurance.

Here alone we have a vast leap in the cost of health care and in this case it can be laid almost 100% at the feet of litigation and nothing else.

10

I’m not going to let it get into a GD so I won’t address your arguments (but I could). I recognize that I am not the most objective person in the world on this subject but I think that your characterization of events is a little off too. There are a bazillion statistics on this issue and I don’t know that I believe any of them (pro-plaintiff or pro-defendant). But I can speak to my personal experience.

MORE TO THE POINT, I think that you misunderstood what I said. I don’t suggest litigation is only 1% of the calculus. I suggested that only 1% of the time is litigation the only cause of the “problem.” But I would suggest that 95% of the time it is blamed as 100% of the cause. The truth is somewhere in between.

In any event . . .
JohnW77707, Esq.

11

Um, let’s read that again.

What they’re saying is that 431 meritless cases were filed as lawsuits; it doesn’t say how many of those made it to trial. It doesn’t even say how many made it to a settlement; for all we know, every single one was thrown out as soon as it got to the judge.

12

A stock answer we were told to give to clients regarding rising premium was “due to terrorist activities, your insurer has had to raise rates in order to stay ahead of the re-insurers’ costs”. I would normally break that down to a more simple explaination, a finger-in-every-pie type of thing. Also, natural disasters such as wildfires and hurricanes cause waves throughout the industry, even in Canada and through Europe, due to re-insurer involvement.

I worked in the general (property and casualty) insurance business in Canada for 13 years. During that time, I watched the number of insurers drop in half due to mergers and takeovers, because of financial woes.

CK Dexter Haven explained everything very clearly for a life point of view, and it translates well to the general side of things.

13

Ok, that has made things a little clearer. I wasn’t aware of the stock trading and so on, so companies making bad choices with an increase in claims is how I am going to understand it - unless someone can tell me that it is wrong.

(note, not saying claims are good or bad - one of the statistics from Australia is that more people are making them, the government has just been giving people big incentives to join private insurance and so now that they have, they want to get their monies worth - the payers use principle)

Thank you all for responding, especially CK Dexter Haven for the very simple explanation. I think that is all I wanted to know, more questions later if I can think of any.
FloChi

14

In general, there is something known as an insurance cycle.

Insurance companies are in a business where their costs must be forecast. In most industries, companies can usually stop short of the point where their costs exceed their revenues. In insurance, competitive pressures can lead insurance companies to write policies that, several years later, they wish they hadn’t.

The result: bankruptsies and consolidation. Then lower competition and higher profits. Then, entry into the business and pressures to lower premiums. etc.

http://www.smh.com.au/articles/2002/04/30/1019441371312.htm

15

True but merely having to litigate a case is a cost unto itself and a significant one at that even if the end result is the case being thrown out.

16

In Australia, there has been the phenomenon of women particulary in rural communities being forced to travel hundreds of miles to give birth in big cities, because litigation over neonatal death had raised obstetric insurance premiums to such a level that many doctors refused to offer the service.

17

Sorry that was a bit lame of me to give no cites. Here are some:

Problem of spiralling medical liability insurance premiums in Australia - very interesting IV transcript from an ABC show

Mississippi doctors dropping obstetrics due to soaring liability costs from litigation - scroll down to see it, it does admittedly appear to be a pressure group site (which does not necessarily mean it is false or inaccurate)

18

Insurance according to Ambrose Bierce.