Insurance:

The basic idea:

By combining the contributions of many within a pool of people, the expenses of the pool related
to unforeseen circumstances over a period of time can be paid.

Assume there is a population of 100 people.

Ten people (10% of population) are expected to have expenses related to unforeseen events of
$100.00 each over the next year.

Nine people (9% of population) are expected to have expenses related to unforeseen events of
$200.00 each over the next year.

One person (1% of population) is expected to have expenses related to unforeseen events of
$2,000.00 over the next year.

Consequently, the expected expenses for unforeseen events over the next year are $4,800.00.

$ 4,800.00=10× ( $ 100.00 )+ 9 × ( $ 200.00 ) +1× ( $ 2,000.00 )

If everyone in the pool pays a premium of $50.00 to an insurance company, $5,000.00 (i.e.
$5,000.00 = $50.00 × 100) will be available for the expected expenses of $4,800.00 which
allows for $200.00 of profit for the insurance company assuming expenses occur as expected.

Basically, this is how insurance works. All of the pool participants are covered for a particular
type of unforeseen circumstance, however, not everyone in the pool is expected to need the
insurance over the year. In this example, 80% of the people in the pool will pay, but will receive
no benefit from having had the insurance.

Use a deductible of $100.00 to lower the premium

A deductible means the insurance will only pay expenses that are in excess of a certain value. In
our example, set the deductible to $100.00.

Ten people (10% of population) are expected to have expenses related to unforeseen events of
$100.00 each over the next year. These claims are not in excess of the deductible which means
the insurance company will not pay any money for these claims.

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Nine people (9% of population) are expected to have expenses related to unforeseen events of
$200.00 each over the next year. These claims are in excess of the deductible by $100.00 (i.e.
$200.00 - $100.00) which means the insurance company will pay each of these people $100.00.

One person (1% of population) is expected to have expenses related to unforeseen events of
$2,000.00 over the next year. This claim is in excess of the deductible by $1,900.00 (i.e.
$2,000.00 - $100.00) which means the insurance company will pay this person $1,900.00.

Consequently, the expected expenses for unforeseen events with a $100.00 deductible over the
next year are $2,800.00.

$ 2,800.00=10 × ( $ 0.00 )+ 9× ( $ 100.00 )+1 × ( $ 1,900.00 )

Making the same $200.00 profit, the insurance company can lower the premium to $30.00 a
person.

Insurance company profit = ($30.00 × 100) - $2,800.00 = $200.00

In viewing this example, one can see how a deductible allows for premiums to be lowered.

Use a “cap” to lower the premium:

A “cap” is when coverage stops after a particular amount of expense has been reached. Suppose
in the current example there is a “cap” of $1,200.00 in coverage.

Ten people (10% of population) are expected to have expenses related to unforeseen events of
$100.00 each over the next year.

Nine people (9% of population) are expected to have expenses related to unforeseen events of
$200.00 each over the next year.

One person (1% of population) is expected to have expenses related to unforeseen events of
$2,000.00 over the next year. However, the expenses are not covered beyond $1,200.00 due to
the “cap”, making the expense for the insurance pool $1,200.00 instead of $2,000.00

Consequently, the expected expenses for unforeseen events over the next year are $4,000.00.

$ 4,000.00=10× ( $ 100.00 )+ 9 × ( $ 200.00 ) +1× ( $ 1,200.00 )

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Making the same $200.00 profit, the insurance company can lower the premium to $42.00 a
person.

Insurance company profit = ($42.00 × 100) - $4,000.00 = $200.00

In viewing this example, one can see how a cap allows for premiums to be lowered.

Combining a cap and a deductible:

Using the previous two examples, apply a cap of $1,200.00 and a deductible of $100.00.

Ten people (10% of population) are expected to have expenses related to unforeseen events of
$100.00 each over the next year. These claims are not in excess of the deductible which means
the insurance company will not pay any money for these claims.

Nine people (9% of population) are expected to have expenses related to unforeseen events of
$200.00 each over the next year. These claims are in excess of the deductible by $100.00 (i.e.
$200.00 - $100.00) which means the insurance company will pay each of these people $100.00.

One person (1% of population) is expected to have expenses related to unforeseen events of
$2,000.00 over the next year. This claim is in excess of the deductible by $1,900.00 (i.e.
$2,000.00 - $100.00) and in excess of the cap of $1,200.00 which means the insurance company
will pay this person $1,200.00 (potentially, depending on how the policy is written, the
deductible may also be applied to the cap making the payout only $1,100.00; we will not assume
this to be the case here).

Consequently, the expected expenses for unforeseen events with a $100.00 deductible over the
next year are $2,100.00.

$ 2,100.00=10 × ( $ 0.00 )+ 9× ( $ 100.00 )+1 × ( $ 1,200.00 )

Making the same $200.00 profit, the insurance company can lower the premium to $23.00 a
person.

Insurance company profit = ($23.00 × 100) - $2,100.00 = $200.00

Insurance companies generally use a combination of deductibles and caps to lower premiums.
One should be aware that “cheap” insurance policies may have extensive use of caps and
deductibles that make the policy practically unusable.

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The benefit of segmenting the population:

Using the example above, the premium for full coverage is $50.00 (assuming no caps nor
deductibles). If an insurance company can eliminate the one claim for $2,000.00 and replace it
with a claim for zero dollars, the expected expenses for the pool over the next year become
$2,800.00 (= 10 × ($100.00) + 9 × ($200.00)). This is a much lower value than when the most
expensive claim was part of the pool. The profit for the insurance company becomes $2,200.00
(= $50.00 × 100 - $2,800.00), which is many times higher than before.

Consequently, although expected expenses are determined over a large population, if the pool of
insured people can be selected judiciously, the insurance company has the ability to dramatically
increase profits and/or possibly lower premiums.

Some of the ways insurance companies have been able to decrease a given pool of high expense
individuals are:

 No coverage for pre-existing conditions (i.e. if a condition exists prior to the person
joining the insurance pool, any treatment for that condition is not insured)
 Use some means of segmenting the population (e.g. a low credit score may be an
indicator of someone who will be more likely to have high expenses in the future; charge
this person a higher premium or exclude them from the pool)
 Provide insurance for select organizations that are not as likely to have high expense
people within the organization ( this is another means of segmenting the population, e.g.,
offering life insurance for newborn babies who are not likely to need it in the same
proportion as the general population)

Regulating insurers:

Given this incentive for insurance companies to segment the population to increase profit and
(possibly) lower premiums, what can a government do to make citizens buy insurance?

Some will say that making insurance affordable (note: “affordable” can be interpreted in many
ways) will make everyone buy insurance. Unfortunately, that does not seem to be the case.
Many choose not to buy insurance because they believe the risk is too small to worry about (e.g.
Why buy flood insurance when you live in a desert? Why buy health insurance if you are
generally healthy?).

In many states, insurance premiums are regulated (i.e. set by a regulatory body that determines
what is a “fair” rate for the general population). In the example above, the regulated premium
for full coverage is $50.00 a person (covers expected expenses and leaves some profit).

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However, if the insurance company can segment the population, a large profit can still be
generated even with regulated premiums.

In many states, insurance is mandatory if one intends to engage in a particular activity. For
example, a possible requirement for a driver license is that the driver must be insured.

Currently, some of the ‘segmenting practices” of insurance companies are being considered
“discriminatory” and consequently, illegal. In other words, the government can make
segmenting the population more difficult.

The government can offer tax benefits for employers who provide insurance. This method has
been very effective, but in some ways it makes insurance the burden of the tax payer and does
not guarantee a fully insured population.

As with many issues, there are no easy answers as to who should be insured and at what level of
coverage. However, one can see from the insurance company’s point of view, the incentive for
deductibles, caps, and for segmenting the population within a given pool.

What is reinsurance?

Reinsurance is provided to insurers who want to insure their pool from having too many big
expenses. For example, providing homeowners insurance in one geographic area could lead to a
huge expense due to one catastrophic event. By having reinsurance, the insurer can have
coverage for such an event.

Reinsurers tend to be very large companies that offer coverage on a global basis. By being so
large, a reinsurer has the benefit of globally diversifying insurance risk over a large population
and geographic area.

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How do regulators set premiums?

Using our first example in which expected expenses are $4,800.00 for a pool or population of
100 people, the profit for the insurance company follows this equation:

Profit = (insurance premium × number of people in pool) – expected expenses

Putting in values from our example:

Profit = (insurance premium × 100) - $4,800.00

The “breakeven premium” is when the premium is set by having profit equal zero:

0 = (insurance premium × number of people in pool) – expected expenses

breakeven premium = expected expenses ÷ number of people in pool

Putting in values from our example:

breakeven premium = $4,800.00 ÷ 100 = $48.00

Consequently, if the insurer is expected to make a profit, the premium will need to be in excess
of $48.00 per person in the pool.

The regulator must then determine what is a reasonable profit. If the regulator believes $200.00
is a reasonable profit, the premium is set in the following manner based on the profit equation:

$200.00 = (insurance premium × 100) - $4,800.00

insurance premium = ($200.00 + $4,800.00) ÷ 100 = $50.00

The general equation is as follows:

insurance premium = (profit + expected expenses) ÷ number of people in pool

Note: setting profit to zero in the above equation will result in calculating the breakeven
premium