In part 1 of this series on the experience subsidy, we looked at how premium rates are set. Today we are going to look at another one of the facts of life: aging. Everybody does it, and each year we are all another year older.
As we get a little older every year we get a little bit less healthy. As our health decreases, our healthcare expenses increase.
Let’s look back at the group we used to set premiums: it was 10,000 people, expecting $1,000,000 in claims, for an average claim of $100, which means a premium of $100.
This doesn’t mean we expect everybody in the group to have exactly $100 in medical expenses during the year. Far from it.
Let’s take a closer look at those 10,000 people. If all 10,000 people were exactly the same age, same health, same gender, then we would expect them all to have the same claims per person. But we know that no group is actually like that.
It turns out our group actually looks like this:
2,000 are age 20
2,000 are age 30
2,000 are age 40
2,000 are age 50
2,000 are age 60
There are still 10,000 people, and we still expect them to use $1,000,000 in medical benefits, but we don’t expect someone who is 20 to use the same amount as someone who is 60. So we take an even closer look, and see that their expected usage is actually as follows:
2,000 at age 20 used $ 50,000 (or about $25 per person)
2,000 at age 30 used $150,000 (or about $75 per person)
2,000 at age 40 used $200,000 (or about $100 per person)
2,000 at age 50 used $250,000 (or about $125 per person)
2,000 at age 60 used $350,000 (or about $175 per person)
There are still 10,000 people, still paying $1,000,000 in premiums, and they’re all still only paying $100 per person. But a person who is age 60 is actually getting more benefit than they’re paying for! And a person who is 20 is actually getting less! In effect, the 20 year olds are subsidizing the coverage for the people who are 60.
This spreading of costs is the fundamental function of insurance.
In reality this spreading actually looks something like this: