Understanding Insurance

It is clear to me from reading public reaction to arguments made in the Supreme Court this week on the constitutionality of the new healthcare law, that many people do not understand the concept of insurance.

Insurance is a means for a group of people to share the financial burden from losses that are unpredictable for the individual members, but predictable for the group as a whole. All members of the group contribute to a pool of money that is used to pay for individual losses when the need arises. Insurance is not a means for getting other people, corporations, or governments outside of the group to pay for losses. It is the members of the group that pay for losses and share in the benefits.

Insurance agreements work best when the loss events are truly random occurrences for individuals, but have well known probabilities so that the loss rate for a large population is a known quantity. I cannot know for certain if my house will be struck by lightening this year, but I do know that it is a certainty that someone's house in my community will be struck by lightening. If everyone contributes a small amount to an insurance pool so that the total equals the expected communal cost of lightning strikes, then those that do experience lightening strikes will not suffer a catastrophic loss. Not knowing who among the group will suffer a loss that is almost certain to occur, motivates everyone to contribute to the insurance pool.

Unpredictability is what makes an insurance contract possible. Whenever loss events become predictable, the entire concept breaks down. There are two ways that predictability can enter the system.

•People's behavior: The likelihood of an auto accident is partly random and partly the result of a driver's skill and tolerance for risk. Because these traits tend to correlate with demographics, market pressures arise for insurance pools to either exclude, or demand higher payments from people who fit certain demographic profiles. As a result, teenage boys pay more for auto insurance than middle-aged moms. A person with a history of traffic infractions and accidents might not be able to purchase auto insurance. Even though in the auto insurance market people are treated differently solely because of age, gender, and prior history, these pricing practices are not considered discriminatory.

• Past events: Obviously you cannot insure the past or else no one would contribute to the insurance pool for the future. Unlike the future, the past is entirely predictable because it has happened. No state would sell lottery tickets after the drawing. No bookie would accept bets on a football game after it has been played. No auto insurance company will sell a policy to someone after that person crashed. If this were allowed all these businesses would be broke in a matter of weeks.

I feel like I am stating the obvious, but many people in the healthcare debate do not understand these points. My people are outraged that the new law forces everyone to buy health insurance, and at the same time support the provision in the law that forbids insurance companies from denying coverage to people with pre-existing conditions. But if no one bought health insurance until it was needed, no pool of money would exist to pay for claims. The insurance model would breakdown quickly and no one would have insurance. The belief that it is possible to have universal healthcare coverage without a universal mandate to contribute is completely irrational.

In fact, without the new healthcare law the insurance model will breakdown in the near future. Too much concerning an individual's need for healthcare is predictable. Age and prior history are big factors in predicting healthcare costs for an individual, and just like for auto insurance, market pressures have arisen to exclude older and sicker individuals from insurance pools, either by barring them or pricing the insurance out of reach. But, unlike auto insurance, for which most states mandate coverage in order to drive, there has not been a health insurance mandate, so there is little incentive for the young and healthy to contribute to insurance pools that pay the cost of care for the aged and ill. Financing the healthcare system through a patchwork of private insurance plans simply isn't working because the predictability of the need for healthcare undermines the entire concept of insurance.

Opponents of the new healthcare law argue that mandated health insurance is different from mandated auto insurance because people can choose not to own or operate motor vehicles. Therefore it is possible to opt out of paying for auto insurance. But the irony is that as a consequence of our mortality, the need for healthcare is truly universal. Even though many people would prefer not to pay for health insurance and to opt out of the healthcare system, that choice is not possible. Almost everyone will need healthcare at some point in his or her life and federal law already requires that emergency rooms treat all patients. That means that healthcare is already socialized.

Unfortunately the emergency room is the most expensive and inefficient place to provide healthcare, and many uninsured are using emergency room services and not paying because they have no other choice. This practice further drives up insurance costs for those that do pay and prices more people out of the health insurance market. The current system is spiraling out of control. Eventually when so few people are insured that the healthcare system can no longer cover its overhead, it will experience a financial crisis with an unpredictable outcome.

The demand for healthcare is universal and government works best when addressing universal needs. The ideologues who denounce all government interventions ignore the fact that without government action there would be no Interstate highway system, no universal electrical service, no universal phone service, no Internet, no national defense, and the list goes on. Private enterprise could not have provided these services that we regard as essential to the modern functioning of our society. The loud voices denouncing all government intervention in the marketplace ignore reams of facts. Conservatives may long for a simpler past, but I doubt many of them would be willing to go back and live in the past, and give up all the modern conveniences they take for granted today.

Obama's affordable healthcare law is not a perfect solution, but first attempts to solve complex problems always need modifications. Scrapping the law and doing nothing leaves in place a healthcare financing system that is unsustainable. It is time to stop the shouting and have a serious, informed, and reasonable discussion on how to move forward with our nation's healthcare policies. Unfortunately in our current political climate, characterized by fear mongering, rigid ideologies, insatiable greed, and blind irrationality, I don't see that happening.

Save Big by Saving Small

With the New Year upon us, the number of media stories on financial planning is exceeded only by the number on weight-loss. Most of us don't need sweeping changes to our finances. However, identifying and avoiding small-dollar losses can add up over the course of a year. Here are some small ways to save big.

Compare weight not size. For food items, large containers often cost more than small ones. But, frequently the actual amount of food in the big container is the same or only slightly more than the smaller one-usually not enough more to justify the higher price. Compare the price per pound-in small print-when you shop, not the large-print price per container.

Buy only the amount of food that you need. Bulk purchases to "save money" can actually cost more when items are thrown out after spoiling. When you shop, ignore the suggested number of items to purchase. Signs created by retailers, such as "2 for $5," or "4 for $10," are for their convenience, not yours. In most instances a purchase of a lesser number of items will be automatically pro-rated at the register. If that doesn't happen, buy from a different store.

Consider the total cost of a purchase rather than just the price. Long distance drives to chase sale prices can cost more for gas than you save on the purchase. Visit ComputeGasSavings to determine how far you should drive for a lower price. Even chasing down low-price gas can get expensive. At $3 per gallon and climbing, driving long distances, or idling your car in long lines to save a few cents per gallon on gas, can cost more than the savings.

Start a savings fund for home and vehicle repairs. Because few people budget for these recurring expenses, most are forced to pay with credit. Paying cash for needed repairs is much cheaper than accumulating credit card interest. Look over your repair receipts for the past couple of years to get a feel for how much you spend. It could easily be $1200 to $1800, over the course of year. That averages to $100 to $150 per month. Start setting aside $100 per month now for repairs so that you are financially prepared for these "emergencies."

Ask your insurance agent how much you would save by increasing your deductibles. Over the long run it might be cheaper to pay out-of-pocket for life's little mishaps than to pay extra year-after-year for a low deductible. Would you pay for a small repair (less than $500) on your own rather than report it to your insurance company and risk a rate increase? If the answer to that question is yes, your deductible should be $500, not the standard $250 that comes with most policies.

Avoid Extended Warranties. Almost all electronic devices and appliances become obsolete before they break down. Lots of people have stories to tell about an extended warranty on a new purchase that proved valuable. But, these same people forget about the dozens of problem-free devices that they have bought through the years. A 10 to 20% extra surcharge on each item for an extended warranty added up to far more than the cost of that one repair. If you make it a rule to always decline extended warranties, you will save more than enough money in the long run to pay for the few repairs that you actually need.

Increase your retirement contribution the next time you receive a raise. Put half of the additional income into your retirement account. You will save on taxes, increase your future retirement income, and still see more money in your paycheck.

In fact, if you examine some of the small ways to save money that I've mentioned, it's possible that you could find $100 per month of unnecessary expenses. That is the equivalent of a raise that could be set aside and invested for the future.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy