Why Does Health Insurance Cost So Much?
And how many healthy people need to buy insurance to keep costs low?
My last piece “Is Health Insurance Even Worth It Anymore?” ran the thought experiment of forgoing insurance and paying cash. Now let’s run the thought experiment of how insurance can get to be so wildly expensive.
I saw Alex Berenson post this thread:
$50,000 a year for premiums is too much. The median family income is just above $100,000, meaning they’d spend half of their income just to have health insurance.
How in the world did insurance get so expensive?
Aside from the fact that I don’t believe $50,000 plans are at all the norm in ACA individual exchanges (although $30,000 family plans are quite common), I can think of two contributing reasons:
The risk pool isn’t very healthy, because a healthy risk pool lowers required premiums for everyone.
Insurers cover every single medical expense, which means they have to raise premiums to pay out expected claims.
Let’s dive into these two ideas.
1. A Risk Pool Without Lots of Healthy People Leads to Expensive Insurance
Let’s run some numbers to see why.
Example 1: Really healthy Risk Pool (90% Healthy)
Imagine there are ten people who buy insurance in a risk pool. None of them expect to be sick and all are generally healthy. Nine of them have low-cost years and end up spending $1,000 on medical care. The tenth has a bad year and has medical costs of $11,000. How much should should an insurer charge them for premiums at the beginning of the year?
In our overly simplified example, premiums come to $2,000 per person.
Example 2: Unhealthy Risk Pool (60% Healthy)
Let’s make more people have medical events. Now forty percent of the risk pool has costs that total $11,000 in a year.
An insurance company would rightly increase premiums by $3,000 (up 150%) in order to insure this simplified risk pool.
Example 3: Catastrophic Year Risk Pool ($100,000 Covered Expense)
Let’s go back to a healthy risk pool where ninety percent of covered individuals only have $1,000 in medical costs. But one person requires a life-saving procedure or medicine and has costs of $100,000. What happens to premiums then?
Now we start to see how insurance can get so expensive and why it is crucial that as many healthy people as possible buy health insurance.
You can also start to see why healthy people (who tend to be younger) aren’t as interested in purchasing health insurance. Paying $9,900 more than their annual cost in this example as opposed to $1,000 more than their annual cost will make more of them consider forgoing insurance in the first place.
Lastly, let’s see how uncertainty about expenses increases premium costs, because insurers need to build in the possibility of losing a lot of money.
Example 4: A More Real Life Example of How Premiums Are Determined
Let’s take our existing three scenarios and find out what premiums should look like if they’re all equally likely to happen.
This is the most interesting of the results, because you can infer a lot about premium pricing.
If an insurer charges annual premiums of $5,967 to these ten people, they could range from making $39,667 in example one, to making $9,667 in example two, to losing $49,333 in example three. On average, it’s a 16 percent profit margin. (UnitedHealth’s gross, operating, and net margins from 2011 to 2025 are here.)
What would you do if you were an insurance company, knowing that if you priced things wrong you could operate deeply in the red? My guess is that you overweight the possibility that expenses are high and then charge higher premiums.
If instead of equal probabilities you instead assume likelihoods of 25 percent, 25 percent, and 50 percent for examples 1, 2, and 3, then required premiums jump to $7,200 a year.
Note that these numbers are purely illustrative - I picked them out of thin air. But I think they do a good job of getting people to wrap their heads around insurance pricing. And a sample size of ten means the variance is huge. Once you start running numbers based on previous medical claims with tens of thousands or hundreds of thousands of people, you can see why insurance companies’ profit margins don’t swing by enormous amounts.
Of course, we’ve been operating under the assumption that insurance only covers expenses that need to be insured. There’s another reason why health insurance has gotten more expensive.
2. Health Insurance That Covers More Services Leads to More Expensive Insurance
Almost every medical expense goes through health insurance, but it shouldn’t.
One of the complaints among those of us who like markets and less government intervention in health care is that health insurance doesn’t act like insurance anymore. It functions as pre-payment for all medical care.
Insurers are the intermediary for almost every medical event or coverage, and it leads to a situation where patients never see prices and end up paying much more for the sum of their medical care than they otherwise would.
The ACA added the ten categories of Essential Health Benefits to all individual and small group plans. It also basically killed the catastrophic health insurance market. It told insurers that they would have to cover more and more services if they wanted to offer insurance at all. As a result, premiums are higher because insurers are on the hook for more possible costs.
As an example, let’s say there are two insurance plans. The first operates like insurance plans are required to operate now: It covers routine, predictable, and low-cost care like preventive visits, simple blood panels, ongoing medication, common outpatient procedures, and many other mandated services.
The second operates like car insurance: Routine, predictable and low-cost care is paid out of pocket and not through insurance. It’s the equivalent of paying for tanks of gas, oil changes, and tire rotations out of pocket but having insurance for when your car gets hit by another car.
Which one is going to have higher premiums? Obviously the first plan. Covered expenses are expected to be higher, so premiums will necessarily be higher. And since premiums are higher, expected out-of-pocket spending is lower, leading to less price sensitivity.
Your objection is probably, “Yes, but if you remove coverage, then people are going to face higher bills.” I would contend that’s not true if what is removed are the things that shouldn’t be covered by insurance in the first place, and that people will naturally shop for better than a third party payer would.
Not all preventative measures save money. In fact, the ones that do are the ones that insurance companies are going to voluntarily cover if they’re not required to in the first place. If we mandate that everyone should receive annual MRIs to check for early tumors, we’d certainly find more early cancers. But resources are scarce and it seems entirely possible (based on how expensive MRIs are) that the cost would outweigh the benefits of early detection from a cost perspective.
Another thought experiment, brought to you by Anthony DiGiorgio: How much more expensive would your car insurance be if it covered gasoline, oil changes, and new tires? And how long would the wait be to get new tires when you got a flat and needed a new one? If the government, or your insurance company, were the ones handling payment, there is no way that the average tire cost would go down.
Takeaways:
Our goal should be a functioning, competitive health insurance market with lots of options, really broad risk pools, and coverage for medical expenses where insurance makes sense.
Subsidizing insurance companies (which makes sick people appear healthy, because they cost less) is one way to drive down the cost of premiums. Another is to broaden the risk pools. And another is to reform health insurance so that it doesn’t cover the equivalent of tires and oil changes.