The proposed socialized medicine scheme aka ObamaCare fails the axiom of low frequency and high severity within the theory of insurance. Low frequency and high severity risks are the point in the risk management matrix where the insurance mechanism is most efficient and qualifies for deployment. (1) (2) (3)
The socialized medicine scheme's mandated coverage proposal merely moves one toward low frequency and low severity within the risk management matrix. This is a highly inefficient position within the theory of insurance and hence inefficient positions lead to increased costs.
What is the risk management matrix and why does it create an axiom? Why is risk management and self insurance important within the theory of insurance? Why does ObamaCare create an inefficient transfer of risk and hence becomes an insurance cost and health-care cost increase driver ?
The Risk Management Matrix
The most effective use of insurance is to find the simplest and least expensive solution that actually solves the risk problem. That point is found when you have a low frequency risk that results in a high severity result. That is, insurance is most effective when applied to catastrophic events that occur infrequently. (4)
The risk management matrix depicted above is the simplest risk management matrix in the theory of insurance. This particular simple matrix however creates an axiom within the theory of insurance. The matrix can also be expressed as a mathematical formula. (5) The matrix is also a building block to much more complicated risk management matrix used for specific risk situations. (6) (7) (8) The risk management matrix is also used in other disciplines. (9) (10) (11) (12)
Within the matrix you find the combination of high frequency-low severity. The most popular example of this type of risk is your weekly grocery bill. Hence insuring the weekly grocery bill would cost exactly the value of your weekly grocery bill. Using insurance would be ineffective. In high frequency-low severity risks the most effective solution is to retain the risk (self insure) and use loss control and risk management techniques such as using shopping lists, clipping coupons, and shopping grocery store prices.
The next block within the matrix is low frequency and low severity. An example would be replacing a light bulb. The frequency occurs every six months or so and the cost to replace a light bulb is modest. Hence insurance would be ineffective. In low frequency-low severity risks the most effective solution is to retain the risk and self insure.
The next risk is the one that produces high frequency-high severity results. An example would be to build a home within the crater of an active volcano. The event is un-insurable. The chances of loss are high and the severity of loss is extreme. In this case risk avoidance is the only technique available.
The final combination is low frequency and high severity risks. This is the situation where insurance is a viable option. For example, pure risk in the field of property insurance such as fire, tornadoes, and lightning strikes create high severity losses. However, the chances of fire, tornadoes, and lightning strikes are of low frequency and random in nature over a wide geographic area. Hence the risk can be transferred to an insurer for a modest consideration (premium). (13)
Why is risk management and self insurance important within the theory of insurance?
Obviously risk management produces the risk matrix depicted above which indicates when insurance is viable. However, the study of risk management produces techniques such as risk reduction, risk loss control, and risk avoidance. Risk reduction from the loss of lightning strikes would be to install lightning rods. Risk loss control regarding lightning losses would be to install smoke detectors and fire extinguishers on each level of a property exposure. Risk avoidance of lightning exposures would be to not own property hence the property loss exposure is eliminated.
However, if a loss exposure is of low frequency and high severity and hence insurance becomes a viable option, and one decides to transfer the risk to an insurer for a consideration (premium), what amount of consideration (premium) does one want to pay to transfer the risk? Which brings you to another risk management technique known as risk retention. How can the premium be reduced through risk retention?
If the consumer can not avoid a risk, has deployed risk reduction and loss control, and has decided to tranfer the risk by the purchase of insurance, the next question is what amount of a risk can be retained? On one extreme of the risk retention spectrum is to retain a majority of a risk. On the other end of the spectrum is to have a zero deductible if loss occurs. Obviously retaining the majority of a risk results with the insurer having a much smaller obligation which in turn generates a small premium outlay for insurance. A zero deductible coverage results in a larger obligation by the insurer resulting in a relatively high premium outlay.
Hence risk retention is a cost management technique when insurance is the desirable avenue of handling a risk. Higher risk retention results in lower insurance costs.
Why does ObamaCare create an inefficient transfer of risk?
The mandated coverage within ObamaCare requires (mandates) low major medical deductibles and ancillary benefits such as low doctor office co-pays and low drug card co-pays. In other words, the mandated coverage leads to mandated risk retention. It mandates low risk retention and we know the lower the risk retention the higher the cost of insurance.
Low doctor office co-pays, low drug card co-pays, and a low major medical deductible means you are moving within the risk matrix (diagram above) toward low frequency-low severity losses. You are also taking a catastrophic coverage such as major medical insurance and attaching a very low risk rention dollar amount and hence settling for a very high cost. Any movement in the matrix away from low frequency and high severity block to any other block within the risk matrix leads to ever increasing insurance costs. Retaining small amounts of catastrophic coverage leads to high cost insurance. In other words, you are casting a blind eye at the insurance axiom produced by the risk management matrix and further driving up the cost of catastropnic coverage.
Mandated low risk retention and the consequential third party effect and over utilization effect.
When risk retention is very low the group of insureds generally suffer from the third party payer effect caused by the mere existence of insurance. That is to say, insurance causes a disconnect between the provider of health-care and the consumer of health-care. The consumer disregards the cost of a health-care event as the insurance will pay for the health-care event. Hence the cost of a particular health-care event is dismissed by the consumer. If the consumer was paying for the particular heath-care event out of pocket, then the consumer would be very cost sensitive and sensitive to what amount of diagnostic procedures deemed necessary. Insurance has the effect of removing the cost and amount of health-care procedures the consumer demands.
Low risk retention also causes over utilization of health-care resources. If the insured faces a very small outlay in order to access health-care, then the insured is much more disposed to use health-care resources. Low deductibles and/or co-pays cause over utilization.
Freedom to choose.
Risk is a very individualistic problem/measurement. One individual is willing to completely self insure as they have large financial resources. Another individual is willing to retain a large amount of risk e.g. the first $10,000 of a risk as they have the resources to retain larger amounts of risk. Other insureds deploy risk management techniques and can retain more modest amounts such as $5,000. Finally you have a segment of insureds that are willing to pay more in premium as they are either unwilling to retain risk or would rather pay a higher premium as they can not currently retain risk (in effect financing retention).
Failure to follow insurance theory as spelled out by the axiom of the risk management matrix will cause insurance costs to rise. Mandating low levels of risk retention cause the third party payer effect and over utilization effect which are major cost drivers within insurance cost. Mandated coverage eliminates the consumers freedom to choose.
When risk management is discarded, failure to manage risks causes insurance prices to rise. ObamaCare is a plan, in which the plan itself, will from the very beginning cause prices to accelerate.
Note: the underlying cost driver of health insurance is the cost of the resource known as health-care. However, you can design the insurance mechanism in such a way to become a second cost diver that then magnifies the underlying base cost driver. Designing insurance to reduce cost should be the over aching strategy not creating an insurance design that merely drives up costs.