What Is Insurance, and What Is Not

The Affordable Healthcare Act (ACA) has triggered a significant increase in discourse on the issue of “health insurance”. This may be something of a misnomer.
Wikipedia defines insurance as ”the equitable transfer of the risk of loss, from one entity to another in exchange for payment”. Let’s look at some familiar examples, auto, home and life insurance.

Auto insurance is designed to protect the insured from loss both to their vehicle and for any damage done to other’s person or property. Rates are based on the drivers record, vehicle value, expected use, location and such other criteria as the insurance industry has determined as being relevant to assessing risk. The insured’s income is generally not material.

For homeowners insurance there is a similar process, incorporating such criteria as value, location, proximity of fire protection services and such other factors as may be used by the insurance industry to assess risk. The homeowners income tax returns are not requested.

For life insurance, the major factors include the age and health of the insured. Again, income is not a factor.

These are examples of insurance, where the premium paid equates to the risk involved. In other words, bad drivers pay more than good drivers.

Healthcare is different. Prior to ACA, the majority of Americans were covered through their employer, Medicaid or Medicare and virtually the only measure was eligibility, as defined. In the employer based universe, the insurance industry acts primarily as administrators, with the employer bearing the full cost based on actual results rather than through an actuarial model with the insurance industry accepting all of the risk. This is not insurance. This is an employer paid benefit, like wages, that covers the employee’s healthcare costs, subject to agreed to employee contributions, deductibles and copays.

Individuals not covered by an employer or part of some other group, were subject to the realities of insurance and their eligibility and premiums were based on the insurance industry’s assessment of the risks involved in issuing a policy. As a practical matter, many individuals were unable to afford and/or obtain health insurance.

Obviously, the text book version of insurance doesn’t work for healthcare.

In an effort to address this issue, ACA appears to be an attempt to persuade the healthiest and wealthiest to overpay for the healthcare services they receive, thereby providing excess resources to subsidize the poorest and sickest, with government (the taxpayers) making up any shortfall. In this regard, ACA is precipitating numerous changes in how Americans receive healthcare benefits.

The question for investors is, what are the changes, (the rules seem to change frequently) and how will they affect investment opportunities? It is clear that there will be some changes in how various segments of the investor owned healthcare industry generate income. Investors should carefully consider how these changes will affect margins, market shares and other factors that may prove to be material in determining investment returns.

When the smoke finally clears, are we headed towards “Medicare for all”? By and large, Medicare works, but is very expensive. Most countries with universal coverage healthcare plans find that income tax rates cannot be increased enough to provide the required funding. The solution has typically revolved around some kind of consumption tax strategy. While this kind of tax is generally regressive, it can raise a lot of money. Every body gets taxed from their first day to their last.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA