How Health Insurance Works

Individuals and families buy automobile, life, fire, and health insurance policies to protect themselves from catastrophic financial harm from rare events. No one buys "food insurance" because food costs, though large, are unavoidable and predictable. Why pay a middle-man overhead costs to reimburse us for our grocery bills? Nor do we buy rent insurance, or clothes insurance.

We buy life insurance during our working years, because death is very unlikely but financially ruinous to our families if it occurs. For a few hundred dollars a year we can buy support for our families worth hundreds of thousands of dollars if we die. We buy automobile liability insurance because we can protect ourselves from losing huge amounts if we cause an accident.

True health insurance protects our families from ruinous costs of illness. Like most employers, the Federal Government does not offer employees this kind of insurance alone. Instead, it offers various combinations of true insurance and "prepaid" health care. The part of your premium that prepays health care by making advance payment for routine bills will generally equal about what you would have spent by paying the bills directly. However, you wind up paying far less than this because prepaid health care isn't counted as taxable income. Most Federal employees save about one-third of their health care costs because of this exclusion, as explained in "How Much Money Can I Save by Switching FEHB Plans."

Unfortunately, prepaid health care creates incentives for enrollees to waste money because the insurance company pays the bill. Prepaid health care may be the single largest cause of wasteful health care spending which, according to some estimates, may be as high as one third of all health care expenditures. There are two major ways to reduce waste. First, health maintenance organizations (HMOs) and other managed care arrangements such as preferred provider organizations (PPOs) use payment incentives for doctors and hospitals to contain costs. Second, high deductible (HDHP) and consumer-driven plans with savings accounts create incentives for enrollees to save costs through prudent shopping decisions. We analyze the advantages and disadvantages of these plans in our analysis of "Types of FEHB Plans."

How much and what kind of coverage is true insurance? How much is prepaid health care? These questions have no simple answer. A policy protecting against catastrophic medical expense for one family is simply a prepaid health care policy for another family. To a GS-5 with three dependents, $5,000 is a hardship, and $20,000 a heavy burden. To a GS-15 with no dependents, even $20,000 may not be a hardship.