Saturday, January 25, 2014

ACA: Insurance -or- Politico Scheme of Focused Benefit/Dispersed Price?

In the book, The Basic Bond Book, which is a book for general contractors and sub-contractors to help them understand surety, the book opens with a definition of insurance. The definition is displayed to contrast insurance with the definition of surety which are two different concepts. The comparison of definitions is also displayed to end confusion between the two products. The confusion occurs because insurers offer both insurance and surety products. Being that James and Jane Goodfellow are more familiar with insurance, it follows that people will confuse surety with insurance due to the base issuer of both products.

The definition of insurance offered is as follows:

“Insurance is a two-risk party transfer mechanism whereby one party pays to have another protect it from certain well-defined risks. In purely theoretical terms, insurance is a pool created by a large number of people exposed to a common risk. Each member of the pool contributes to it and any members who suffer loss as a result of the risk assumed may be compensated for that loss by the pool.  The contribution to the pool is determined by an actuarial study of probability of loss. The probability factor determines how much will be charged to pay losses while still leaving the pool solvent.” (1)

One of many basic problems with ACA/Obamacare is that its proponents have based the viability of ACA on one half of the definition of insurance. That is, the “large pool” and/or law of large numbers; is one of the mantra of ACA proponents. Implicitly and explicitly they claim that a large pool of insured’s becomes self solving regarding coverage/price. The second half of the definition is discarded: “The contribution to the pool is determined by an actuarial study of probability of loss. The probability factor determines how much will be charged to pay losses while still leaving the pool solvent.”

As with all chairs with four legs, all legs support the chair. One can not discard a leg or two and expect the chair to function properly or to deliver its intended utility. So it is too with insurance. Discarding the probability of loss and consequently charging premium based on individual exposure units based upon probability of loss, is to create nitwit insurance.

Can you suddenly insure a burning house? Insurance would not be the mechanism. Fire trucks serve better. The insurance premium, if it was possible insurance could be written (which it is not), would be exactly equal to the loss sustained, plus some. If the fire causes $50,000 of loss, then the premium is $50,000 plus the price of insuring a standard exposure unit and claims administration expense.

Can you suddenly insure a burning home and non-burning homes would remain with their current premium? No. Why? The $50,000 loss, if it in fact it could be insured during a current/present fire, would require the $50,000 loss be spread across the non-burning homes as an increased price. The only way for the non-burning homes to remain with their current premium would be to charge the burning home $50,000 plus the premium associated with a standard exposure unit and claims administration expense.

Moreover, if one’s mantra is “large pool” then one needs to go one step further in insurance theory regarding an expanded definition of insurance. The theory of large numbers aka “large pool” demands the pool be populated by homogeneous exposure units, e.g. vehicles, commercial buildings, health of people, life of people, etc. Once the homogenous exposure unit is identified an average exposure unit is determined with above or below average exposure units existing in comparison to the average unit. The “actuarial study of probability of loss” is applied to average exposure, above average and below average exposure units arriving at price that varies based on the probability of loss.

The homogenous exposure unit is only “homogenous” in a very broad sense. Within the broad swath of homogeneous exists differing risk criteria. For example, regarding the homogeneous exposure unit “commercial building” one might find a commercial building built in 2004 with superior construction, a sprinkler system, central fire and burglar systems. Another homogenous exposure unit within “commercial building” might be a commercial building built in 1978, with no updates since time of construction, of frame construction, with no sprinklers nor central fire and burglar systems.

The two commercial buildings have different probability of loss. Hence price differs to insure. If one’s mantra is “large pool”, then one would want to charge differing rates given the above discussion. However, if one merely figures “large pool” is all one needs, then: Superior construction and the price inherent with such construction, safety measures such as sprinkler systems, central fire and burglar systems and the price inherent with such systems and finally age of construction are all tossed aside.

When one tosses aside differences in probability of loss, then the exposure units have disincentives to lower probability of loss. Further, any prior value associated with reducing the probability of loss is destroyed. One arrives at a price that, in the short-run becomes cross subsided and in the long-run a price exists with zero incentive to lower probability of loss.

Returning to the mantra of ACA proponents regarding “large pool” and/or law of large numbers: Is “large pool” an insurance concept -or- is “large pool” a politico collective action concept? Stated alternatively, was an insurance concept/term merely borrowed with no intention of deploying “insurance”? Is the intention to charge the many, for the few with no insurance mechanism intended? Is "insurance" politically-purposely used as a substitute term for "scheme"? Was the greater intention, to camouflage as it were, politico focused benefit/politico dispersed price [scheme], as a happy little insurance plan with a happy little insurance web site?




(1) The Basic Bond Book, second edition, 2001, The Associated General Contractors of America, John J. Curtin Jr., page 1.

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