If you've been reading a lot about health care, you might have come across a fascinating discussion over health insurance rescission. Rescission is a weird-looking word that describes insurers seeking ways to invalidate your health coverage when you try to take out insurance for expensive health care. The insurance industry claims that this affects no more than one-half of one percent of all cases. Rather than parse that dubious claim, I want to explain how the rescission issue encapsulates some of the absurdities of health care finance, and how we could all understand health insurance better if we simply compared it to a Zombie Armageddon.
But first, some background on health care spending. The blogger Taunter, in a great post, looks at the graph below which breaks down percentage of health care spending by percentiles. If you can't read the graph well, here's what you need to know. That small bar on the far right says that 50% of the insured population uses almost no health care at all. Eighty percent is used by the top quintile of spenders and 22% of health spending comes from the 99th percentile -- that is people with more than $35,000 of medical costs a year. Now here's Taunter, and his graph:
It should be fairly clear that the people who do not file insurance claims do not face rescission. The insurance companies will happily deposit their checks. Indeed, even for someone in the 95th percentile, it doesn't make a lot of sense for the insurance company to take the nuclear option of blowing up the policy...
If the top 5% is the absolute largest population for whom rescission would make sense, the probability of having your policy cancelled given that you have filed a claim is fully 10% (0.5% rescission/5.0% of the population). If you take the LA Times estimate that $300mm was saved by abrogating 20,000 policies in California ($15,000/policy), you are somewhere in the 15% zone, depending on the convexity of the top section of population. If, as I suspect, rescission is targeted toward the truly bankrupting cases - the top 1%, the folks with over $35,000 of annual claims who could never be profitable for the carrier - then the probability of having your policy torn up given a massively expensive condition is pushing 50%. One in two.
So any random individual will not lose his health insurance through a rescission claim. But if you are of the group that actually needs to file a claim it could be anywhere from 5% to 50% likely. So if I was a shareholder or executive of an insurance company, and saw that we had very few sick people on our insurance, I'd be very mad. Why? Because one great way to make money is to keep them on the roster, collect their large premiums, and then deny them the care they need when the time comes. Very sick people are probably the easiest to kick off; letting them go before collecting their insurance is leaving money on the table.
How Health Insurance is Like Zombie Insurance...
The current legal structure with rescission is terrible. The reason is very simple: One thing you never want to do in financial engineering is get to a place where something is most valuable to you at the same exact moment as it is least likely someone will pay it out. Let's use a thought-experiment from Donald MacKenzie's End of the World Trade: How much would you pay for the insurance of getting paid $100 if half of American corporations went totally bankrupt? This is End-of-the-World times; Skynet takes over, zombies roam the streets, Bruce Willis and Ben Affleck couldn't destroy that Armageddon asteroid, or as a trader tells MacKenzie, there's "a revolutionary Marxist government in Washington." Normally that insurance is 3 cents a year. During last fall it was 30 cents. That might be a fair price, but you must ask yourself - what are the chances I'll ever collect it? And how do you quantify that? I am on the record fearing zombies over robots, and presumably investment bankers have the most delicious brains, so what are the chances your counterparty will be there to pay you? This is a scenario when the contract in question is most valuable at the moment it is least likely to get paid.
Not all financial instruments work this way - a stock is more valuable when a company has more earnings, when they are most likely to pay dividends. If you put a put option on that company through an exchange, it is valuable as the company is collapsing. If you are foolish enough to buy a put option from that company on itself, that is trouble - they'll owe you the most right as they declare bankruptcy. These bad scenarios are what financial engineers have to look out for sneaking into their contracts, and if the law isn't on your side you are in trouble. Health insurance is like this - the moment you need it the most is exactly the moment where they are going to look to deny your claim. And the legal protections appear to be very weak.
...And Credit Default Swaps and Credit Cards
Another example? Let's look at credit default swap (CDS) contracts. CDS insurance is worth the most to you during a financial collapse; however during a financial collapse is when it is likely your counterparty is also going to collapse. Look at AIG and the monolines in this case. Now as opposed to your health insurance, CDS buyers of insurance have extra legal protection - they demand that colleteral is posted on the position daily to reflect updates in risk. Can you even imagine a universe where you could call your health insurance and say "I think I'll be sick next month - can you show me how you are putting aside money to make sure you'll cover my illness?" If anything you'd be worried they'd start digging into you right then for pre-existing illness and other reasons to kick your claims. Even with this legal protection, the government still had to step in to make sure AIG counterparties got paid.
How about credit cards? People who pay their bills aren't worth much to the credit card companies. People who are in a lot of financial distress are worth a lot. However people who are in a lot of financial distress are often close to declaring bankruptcy, at which point they aren't worth anything. How to thread that needle, keep consumers need the edge of bankruptcy without going over, takes up a lot of innovation and technology. In the end though, the credit card companies found it wasn't enough, and the government was forced to step in with the 2005 Bankruptcy Bill to make sure these credit card companies got paid. Fair enough to them. But when is the government going to step in to make sure American citizens get paid just like the Wall Street and the credit card companies when it comes this to problem?