Insurance these days is a mess. On the one hand, insurance fraud by consumers seems more prevalent than ever. Not just the big ones where cases are fabricated entirely from whole cloth, but minor things like padding out claims to include things that might have been caused by the accident but weren't. On the other hand, the insurance companies are balking at paying out claims per the policy terms more and more, and even refusing to pay out clearly legitimate claims entirely. At this rate, it'll be the death of the insurance industry and that'll be a bad thing for everyone.

How should insurance work? Most people seem to think of insurance as some sort of account they pay into, and that they ought to expect to get back what they paid in. At the same time the insurance companies think the same way, that every customer should pay in enough to cover payouts to them. Both are wrong, really. Insurance is a risk pool. Individual premiums aren't to cover individual payouts, total premiums are to cover total payouts.

Let's look at the classic start of an insurance pool. Say we have a population of 1000 people. There's some nasty thing that can happen to them. It's not common, it only happens to 1 person a year on average. When it happens, it'll cost the person it happens to $1,000,000. Nobody in the population can afford that kind of catastrophic bill, there's no way they can save up enough to cover it and no way they could afford to pay it. But there's only 1 chance in 1000 of it happening to any given person in a given year. So the population gets together to pool their risk. If each person ponies up $1000 each year, they can put that into a pool. That may be a chunk of money, but it won't be ruinous for any one of them. The pool will then cover the cost for whoever the catastrophe happens to.

Now, that may not seem like a good deal. You pay, and you may not ever get anything for your expenses. But look at the math. You pay $1000 a year. Your life expectancy is maybe 90 years, so over your lifetime you'll pay $90,000 for your coverage. If you never wind up the unlucky one, you may think you've wasted $90,000. But you weren't paying to get a payout, what you're paying for is the certainty of not having that million-dollar catastrophe to worry about, not worrying about losing everything you own just because you got unlucky once. And you're only paying 9% of the payout to get that certainty. To me that sounds like a good deal for the peace of mind it gives. If I didn't pay that, I'd have to figure out how to get the full million dollars into a savings account somewhere, and hope and pray I didn't get unlucky before I managed it.

Of course, the pool doesn't run itself. So everybody decides to hire a manager to handle the paperwork. $100,000 a year in flat fee sounds good. That brings the premium everybody has to pay up to $1100/year. And the pool may not need to pay out immediately at the start of the year, so until it's actually needed the money can sit in safe investments earning a bit of interest. The manager can handle the investments, taking a 20% cut of the interest for his troubles and putting the other 80% into the pool to help build a buffer against having to pay out twice in quick succession. Sounds like a good deal for the manager, no? He gets a decent salary and the possibility of a steadily-increasing bonus from the interest, all for handling a little paperwork.

Now, let's look at how it goes wrong.

One way is for the people paying in to start forgetting that they're paying for certainty and begin thinking they're paying for the payout. They start expecting the pool to pay out what they've paid in, and start figuring out ways to get the pool to pay out "what they're entitled to". That drains the pool of money, leaving not enough to cover the full payout when the catastrophe happens to someone. $1000 won't cover the full $1,000,000 payout, and if everyone else is drawing their full $1000 each year that leaves only $1000 for the guy the catastrophe happens to.

They can also try to predict the odds. Genetic tests for health insurance show this best. If you know you're more or less likely than expected to have the catastrophe happen to you, you can skip buying insurance when you're unlikely to need it and only buy it when you know you're more likely than normal to need it. But if that happens a lot, the insurance pool needs to increase it's premiums. It needs to bring in enough every year from participants to cover the payouts for that year, after all. As that happens more and more people will opt to try and play the odds, which drives premiums up even further. Eventually you aren't gaining anything by joining the pool, your premium would have to be nearly the full payout amount because the pool has to assume you're playing the odds too and that's the only way it can insure it's got enough money. By that point as a participant you aren't gaining anything over covering the costs yourself when and if.

Another way is for the pool manager to get greedy. Suppose he can figure out a way to avoid paying out the full $1,000,000 when catastrophe happens. If the pool's taking in $1,000,000 a year but only paying out $900,000, that's $100,000 that the manager knows can safely be invested in things that'll line his pockets a bit more. Over the years that adds up to quite a tidy sum. The manager can bump up the percentage he takes from the interest, or even "invest" the money in things he'll personally profit from, and the pool members won't have any reason to be concerned because the pool's still solidly in the black.

Or the manager can take advantage of the same sort of prediction we mentioned above. If the manager can predict which pool member's going to get hit this year, he can increase the premium for that member to cover the majority of the payout. Notice that he doesn't decrease the premiums for the other members. Now a large chunk of the premium income every year is free and clear. Taken to an extreme, the one person who'll get hit has to cover the full payout himself and the other $999,000 is pure profit for the pool. Or rather, the manager who can take advantage of it knowing he won't need that money to cover an actual payout. But at that point, why should I as a participant buy into the pool? I'm paying my normal premiums every year, but I still have to cover the full cost the one year I'm the unlucky one just as if I hadn't bought in. I'm better off covering the costs when and if myself and saving all the overhead of those years I'm not the unlucky one.

You can see where the above's led. If things keep going the way they are, it simply won't be worthwhile to buy insurance. Policyholders need to stop thinking in terms of getting what they're paying in and start thinking in terms of paying a fixed, known rate to avoid a random, catastrophic payout at some unexpected time. Insurance companies need to stop trying to game the odds and tailor risk more and more individually, and return to pooling risk across a large number of individuals and being satisfied with a fixed income for handling the paperwork. Because if things keep on the way they're going, either people are going to not bother with insurance because it's not any better than paying the costs directly, or people are going to force a single-payer system either by heavy regulation of the insurance companies or by creation of a mandatory government-run insurance pool.