Friday, October 23, 2009

Fun and Games with Preexisting Conditions

Preexisting conditions and buying insurance after-the-fact are two health insurance subjects that have received plenty of press coverage recently. These two subjects need examination.

Commonly Used Definition of Preexisting Conditions

Before you examine "preexisting conditions" within health insurance, you need to look at a generally used definition of preexisting conditions:

Preexisting conditions means an injury or illness:

(a) for which a covered person received medical advice of treatment with in X amount of months immediately preceding the effective date the covered person became insured under the policy; or

(b) which in the opinion of a qualified doctor:

(1) probably began prior to the application effective date the covered person became insured under the policy,

(2) manifested symptoms which would cause an ordinary prudent person to seek diagnosis or treatment within the 12 months immediately preceding the applicable effective date the covered person became insured under the policy.

Why would such a definition exist within a health insurance policy? How come the subject of preexisting conditions occurs within health insurance?

Private Insurance Formation (Private Welfare Plan)

Before we go further into the subject of preexisting conditions, we must examine the reason we organize a private welfare plan and the member characteristics making up the private welfare plan.

One must remember that private insurance can be defined as a private welfare plan. That is, a group of private individuals create a pool of resources to benefit those members (welfare of the group) suffering an insured loss. Hence when you see the logo for XYZ Insurance Company and their trademark slogan and even little commercial jingle, these sometimes very large corporations, at the end of the day, are merely private welfare plans.

The welfare of the group is the reason the private insurance was organized. The pooling of resources among the members allows the group to pay losses that any single member likely can not pay with their own individual resources. Simplistically, 5000 individual members contributing $1,000 each creates a pool of resources of $5,000,000. The pool of resources ($5 million) is used to pay covered losses of members (welfare of the private group). A single member with a loss of $50,000 likely can not easily pay the loss himself/herself, but the pooled resources can easily pay the loss.

Enter Insurance Theory. The risk of the group of members, creating the private welfare plan, needs to be made up of homogeneous risk exposure units spread over a wide geographic area. What does that mean? Homogeneous risk exposure units are categories of like kind items such as: residential homes, commercial buildings, private passenger vehicles, etc.. The risk exposure needs to have similar characteristics and similar measurable risk attributes. Spread over a wide geographic area? This concept means you do not want all the risk grouped into a small contiguous area that can suffer a dramatic loss from one single event e.g. a tornado hits one town and every home in the town, is in fact, a member of the same private welfare plan. The welfare plan's resources are then wiped out in one single loss.

Please remember the reason the group was formed was for the welfare of the group. If additional members are added to the group, the group must have some sort of membership criteria aka underwriting. Do we add only members with well maintained risks and few losses in the last five years? Or do we add new members with poorly maintained risks and immanent losses?

You can go to the extreme and ask: do we add a homeowner member, in a home insurance private welfare plan, with the home currently on fire? Of course not, as it adversely impacts the welfare of the group's resource pool. The mere idea is an attempt not to measure risk. If you added homes currently on fire, the resource pool would be adversely affected and membership fees (premium) to the particular private welfare plan would certainly rise.

Classic Example of Poor Member Selection Criteria

When National Flood Insurance was proposed and eventually passed, the insurance industry was invited to participate. The insurance industry, after a period of time of participation in framing the Flood Insurance Plan, pulled out as their ideas were ignored.

One of the selection criteria problems was that you could apply for a policy, with little or no waiting period, then cancel the policy and receive a refund for the unearned premium.

Interesting happenings followed:

(1) Spring comes and the head waters of the Mississippi River begin to fill up with the water from thawing snow,

(2) if the thaw is too quick, the Mississippi begins to flood,

(3) the flood waters move down the Mississippi,

(4) people in St. Louis and other river communities watch the weather forecast/flood forecast,

(5) if the flood water appear to threaten them, they buy coverage,

(6) if the flood waters pass by, they cancel and collect the remaining premium as a refund,

(6a) if damage occurs, they collect the coverage then cancel the policy to receive the remaining premium as a refund.

Adverse Selection in regards to Membership Criteria

Suppose for a moment you have a private welfare plan and each member's dues/premium is $1,000 per year. However, the membership criteria is suddenly changed to very lax standards.

The risk characteristics of the original group of members are soon changed to a much different set of risk characteristics. This new set of risk characteristics leads to more claims. The increase in claims cause the claims-resource-pool to fall. In order to replenish the resource pool (that pays claims) premiums must rise to $1,000 plus X.

Many of the members do not like the new premium of $1,000 + X. These members seek out another private welfare plan with a lower premium. The alternate private welfare plan with lower premiums has stricter membership criteria. Those who can qualify move their risk to the new plan. Meanwhile, the old plan now has falling membership, the characteristics of the remaining members of the original plan deteriorates as the low risk members, who can qualify elsewhere, flee the plan. Hence we have a lower membership number with higher risk characteristics causing more losses to be paid causing the premium to increase to $1,000 + X +Y.

You can quickly see that without some sort of intervention, the escalating premium due to the increase of risk leading to increased claims causes the less risky members to leave. You eventually have a small group of very risky members with an unaffordable premium.

Back to the beginning: Preexisting Conditions and Buying Insurance After-the-Fact

In the currently proposed socialized medicine scheme your have surely heard how that bad old insurance company uses preexisting conditions. Ah, the evil of it all!

Or, just maybe, preexisting conditions and other underwriting criteria are used to protect the risk integrity of a private welfare plan. In other words, underwriting is used to protect the members (you) against adverse selection and escalating premium costs.

Really? Sure!

Lets say Sam down the street is always buying a new car. Little-do-you-know, but Sam's ability to buy those new cars on a regular basis is because Sam doesn't pay $600 a month for health insurance. Sam's new car is a shiny BMW. Sam loves the car so much, he drives it night and day. Sam drives so much he ends up cross-eyed. Well, that will not do as driving a BMW while cross-eyed really lowers the enjoyability of the driving experience.

Sam learns that the government has dumped the preexisting clause regarding health insurance. Sam signs up for health insurance and gets that cross-eyed problem fixed for $50,000.

Once the problem is solved, Sam realizes that having the BMW and health insurance is cramping his style. Sam learns that his $600 a month premium cost will only equate to the newly government imposed $100 per month fine for not owning health insurance. Hence he dumps the health insurance. Why not Sam thinks! Next time I'm sick I'll merely sign up for health insurance again! Plus the $100 fine is surely cheaper than $600 health insurance premium!

Ah, yes, the evil of it all.

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