In a nutshell, the basis for insurance, in relation to pure risk, is that of: homogenous exposure units spread over a wide geographic area. Yes, you need to have a large enough number of homogenous exposure units in order that the law of large numbers is operative i.e. spreading risk over a large number of homogenous exposure units. The insurer also needs to be able to predict dollar amount of losses from the homogenous exposure units so premiums and investments will equal or exceed losses hence the insurer continuing as a solvent going concern. (1)
One item to consider is the underwriting [selection] of the homogenous exposure units in relation to price. For example, although vehicles are, in general, homogenous and vehicle operators are, in general, homogeneous, vehicles and operators tend to exhibit differences.
Hence the homogenous group has sub-attributes, that might be insurable, other sub-attributes may not be insurable or sub-attributes insurable at differing prices.
An example might help. If the selection criteria in auto insurance is zero losses or violations in the last five years [0/0/5 underwriting] then price P is the outcome. If selection criteria in auto insurance is not more than one loss and not more than one violation in the last five years [1/1/5 underwriting] then the price is P+1. That is, the expected losses of the two otherwise homogeneous groups, exhibiting differing risk selection/attributes, differ, and hence price differs in relation to expected losses.
Therefore, selection (underwriting) is a determinant of price, as is, selection being associated with the law of large numbers, predictable dollars losses and premium level to equal or exceed loss.
One of the base arguments put forth by proponents of ACA/Obamacare is that “pooling risk”, a reference to the law of large numbers, solves all price problems. That selection becomes unimportant and hence premium is equal to or exceeds claims merely due to large numbers.
For a moment assume insurance has only one basis and that is “pooling risk”, as is the debate point put forth by proponents of ACA/Obamacare.
Does one have an example, a real life result, that one can point to regarding testing the proposition that “pooling risk” is the overriding criteria? The answer is yes. How so?
One needs only examine the results of the Pre-Existing Condition Insurance Plan as specified by ACA. The “pooling risk” or large numbers were predicted to be 375,000 signing up for the plan. However, only 135,000 signed up and the plan collapsed under its own weight circa 03/2013.
The $5 billion subsidy allocated to the Pre-Existing Condition Insurance Plan, plus the premium charged to participants, would not cover losses. If the 375,000 had signed up, the plan would have merely collapsed sooner.
It should be noted, that the premium charged, to applicants within the Pre-Existing Condition Insurance Plan, was predetermined. How so? The premium was based on selection based/underwriting based premiums, for a healthy applicant. (2)
Further, come 01/01/2014 the group of insured's within the Pre-Existing Condition Insurance Plan will move to ACA/Obamacare.
Link to the entire NYT article appears below:
http://www.nytimes.com/2013/09/22/us/politics/reignited-battle-over-health-law.html?hp
Notes:
(1) The Economic Theory of Insurance, Karl Borch
http://www.actuaries.org/LIBRARY/ASTIN/vol4no3/252.pdf
(2) Funds run low for health insurance in state ‘high-risk pools’, Washington Post
http://www.washingtonpost.com/national/health-science/2013/02/15/cb9d56ac-779c-11e2-8f84-3e4b513b1a13_story.html?hpid=z1
thehttp://www.actuaries.org/LIBRARY/ASTIN/vol4no3/252.pdf Economic Theory THE ECONOMIC THEORY OF INSURANCE
KARL BORCHHE ECONOMIC THEORY OF INSURANCE
KARL BORCH
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