Here is a special preview of a special addenda to be included in Maximize Your Medicare (2016 Edition).
Health insurance is simply another example of a type of financial contract, called an option. Since we know how to value options (via the Black-Scholes option pricing formula), we can easily apply the basic principles to Medicare.
If you simply use that application, then the obvious value of Medicare, Medigap and Medicare Advantage can be evaluated.
This special section is intended for those with academic backgrounds or practical experience in financial and/or business matters. Or the perversely curious.
Insurance Is An Option
In order to understand the conclusions contained in Maximize Your Medicare, it is important to understand that insurance is, at the end of the day, an option, much like a put or a call on a stock.
The definition of an option may be difficult to grasp. An option is the right to buy or sell a product (for example, a stock) at a particular price, if a certain set of conditions are met. Many people will understand what a put or a call option is, from the financial markets.
The key point is that the value of the contract increases rapidly under certain conditions. A call option on a stock increases in value greatly as the underlying stock approaches the strike price. In a very similar way, the value of health insurance (including Medicare) also rises dramatically if you incur medical costs, because you receive benefits which can exceed your premiums by a great deal.
You may recall the introduction or the practice of this book when I said that “health insurance is not the same as other insurance.” The reasoning that I used was that the value of auto insurance the value stops increasing, because you cannot collect benefits that exceed the value of your car.
However in the health insurance example, value of benefits that you can receive can be unlimited. In fact, the PPACA mandates that the lifetime benefit amount you can receive is unlimited. This fact alone makes health insurance far more valuable than auto insurance, because the upside (value of the benefits received) is unlimited, and that is protected by law.
Health Insurance Is Different
Health insurance is not the same thing as auto insurance or homeowner’s insurance. Nevertheless, this is the kind of comparison that you can hear in every coffee shop, in every corner of the nation. Comparing health insurance to auto insurance is like comparing apples to oranges. They are both a type of fruit, and that is where the similarity ends. It is a fundamentally incorrect comparison to make. Why?
Say you get in a car accident, and you completely wreck your car, but walk away unscathed. What is the cost to you? Do you know? Open a Kelley Blue Book, and you will be able to determine the salvage value of your car within hundreds of dollars. You can replace your car with an almost-exact copy, at a well-defined price.
On the other hand, imagine that you become seriously ill, and are diagnosed with a disease. What are your costs then? Can you predict the price of recovery? You cannot predict when those costs will cease. You cannot predict if you can go back to work in order to repay those new, unknown costs. You cannot calculate it, and your estimate can be tens of thousands of dollars. The cost can bankrupt your household, and the outstanding liability will make you indebted to the government for the remainder of your life.
In other words, the downside of not protecting yourself in case you become seriously ill is many, many, many times worse than getting into a car accident. You cannot estimate the maximum loss of money, time, and well-being if you become ill. And the older your get, the more extreme it becomes, because the likelihood of becoming seriously ill is greater.
Options Are Priced Using Probability
Let’s get back to the comparison between health insurance, Medicare, and options from financial markets. Options are financial contracts that have a mathematically-derived theoretical value. For financial market professionals, this is the widely known Black-Scholes formula. For the purposes of this book, the calculation itself isn’t important, but the formula has intuition which we will address here.
If you look at the Black-Scholes formula, it is largely dependent on probability. To keep it relatively simple, people are familiar with the “bell curve.” This is what statisticians would call a graph of the “standard normal probability” curve. In order to have this, curve, certain assumptions are made. An important assumption is that every data point is independent, i.e. the results of any previous results do not affect the probability of future results. In theory, that sounds right. In practice, however, it is flawed. Why? It isn’t independent if you have specific information about your individual circumstance.
The implication of this fact on health insurance and Medicare is powerful. When you are 64.9 years old, and preparing to consider your Medicare configuration, you will very likely be aware of individual or family health history to some degree. The sellers of health insurance (carriers) are not allowed to adjust the price, for any reason, even if you have specific information. What are some examples of “specific information?” Medical history and family history fits this description.
Let’s look at it from the seller’s (carrier) point of view. If you are the seller, and you will be required to pay benefits if your customer (you) incurs large medical bills, and you knew this in advance, wouldn’t you want to charge that customer a higher premium? In addition, the liabilities that you would incur are potentially unlimited. Wouldn’t you want to charge that customer more? The intuitive answer would be yes, but the fact is that regulations make this impossible. That means that if you have a pre-existing medical condition, or a medical history that makes it very likely that you will require ongoing expensive, medical care, that the price of Medicare Advantage or Medigap are, if anything, too low.
You don’t have to know anything about insurance in order to understand this. Just compare Medicare to the price of health insurance for a 64-year old: high-quality health insurance, which would still be inferior to Medicare, costs more than $1000/month.
Everyone is “Short” an Option
In financial markets, you can benefit, as an investor, if any financial asset goes up OR down (that is possible). You can buy or sell an option, a financial contract, that increases in value if the price of gold increases. In addition, you can also buy or sell a set of securities that go up if the price of gold decreases.
As your healthcare costs increase, your net worth (not to mention your ability to make money), will most likely to decline. The extent of decline has no limit in extreme scenarios. That is very similar to being “short” an option, much like the investor that is short the price of gold, which is damaging to that investor if the spot price of gold increases. Everyone, irrespective of financial resources, is “short” this option, i.e. everyone is getting older, and the probability of requiring medical care is increasing with time.
The bottom line: buying health insurance is like buying an option at a regulated price. That option protects your household net worth, because it allows you to not spend your savings/investments, at the time that you require medical services.
Sources of Volatility
Back to the Black-Scholes formula. The value of a put or a call option increases as volatility increases. In simple terms, that means if there is a wider array of outcomes possible, the shape of the bell curve will be different (but it will be symmetric).
When considering the value of Medicare and healthcare cost planning, the volatility increases under a wide variety of situations. Let’s take a look at a few, and then the value of health insurance, and the specific case of Medicare, can be understood more completely.
Substantial assets. If you have substantial assets, you can use this method of thinking to understand other conclusions. Since health insurance will continue to pay benefits to the policyholder, irrespective of amount, that means that the wealthier the person is, or the more assets that person has, the actual financial value of Medicare or health insurance contract increases. Why is that? The reason it’s simple: you have more to lose (which is the same thing as saying that your volatility is higher). Thus, the contracts protect more, and are therefore, more valuable. Period.
Medical and family history. Let’s say you are a female, and your mother, grandmother, and sisters have been afflicted with breast cancer. Can you say that you are the “average” case? No. Put another way, this female is subject to a wider variety of outcomes, her volatility of outcomes is higher. The price of health insurance is substantially more valuable to you, and the carriers cannot adjust the selling price to reflect this fact.
Financially restrained. For those that need to save every dollar, Medicare Advantage has all the advantages listed above, and another important one. Every Medicare Advantage plan must always include an annual out of pocket maximum limit. The value of the option is high, and when coupled with financial assistance or Medicare Advantage plans with no additional premium, the cost is very, very low.
The bottom line: health insurance, especially under the Affordable Care Act, and certainly under Medicare, is, if anything, and underpriced way to protect your assets, irrespective of the level of your household net worth.
Comparing Apples to Apples
Much of the confusion regarding Medicare is that there are a wide variety of choices and wide differences in price. Much of the logic and analysis of how to approach Medicare is actually the result of thinking about comparing the options that you enjoy (due to rules of Medicare) and comparing the benefits that you can receive, for a particular price.
Let’s take Medigap Plans C and F. If you look at the grid, they differ in only one regard: the Part B Excess Charge. Under Plan C, the patient/beneficiary is responsible for the Part B Excess Charge. Under Plan F, the carrier will pay for the Part B Excess Charge. If you put the two plans together, then it should be self-evident: Plan F is slightly superior in coverage, since the language is identical in every other respect, down to the last letter.
Now the question will be if the difference in premium is “worth it.” It should be clear that if you can purchase both plans at the identical price, then Plan F will provide a slightly better set of benefits for no extra cost, when compared to Plan C. Usually, Plan F is more expensive than Plan C. Depending on how much the extra coverage is “worth,” Plan F may or may not be a better alternative.
How do you decide what it is “worth?” Just re-read this chapter from the beginning: if you are subject to more volatility (due to your health situation or financial results), then the extra coverage is worth more to you. It is as simple as that. You can continue this process to consider every aspect of benefits that you receive.
Comparing Medicare Advantage plans is notably more difficult. Recall from an earlier chapter, Medicare Advantage is an annual contract, which means the exercise of comparing “apples to apples” will change every year. It is practically impossible to believe that this situation will cease to exist. Why? The funds from the CMS change every year, and there are multiple competitors (carriers) trying to win more customers (you) every year.
Medigap vs. Medicare Advantage Revisited
Many say that it is very difficult to determine if Medigap or Medicare Advantage is superior. Earlier in this book, it is stated that the coverage of Medigap is superior due to the cost-sharing details are lower, and cannot be changed over time. We can use the information from this addenda in order to help comparing Medigap to Medicare Advantage.
Let’s say you have two Agreements, and you already know that the language of Agreement 1 will not change through time, but under Agreement 2, the other party can change the language. Let’s now compare the prices, and even if the benefits are identical, it should be clear that Agreement 1 is worth more than Agreement 2. In this simple example, Agreement 1 is Medigap, and Agreement 2 is Medicare Advantage.
Remember that you have the unrestricted right to change from Agreement 1 (Medigap) to Agreement 2 (Medicare Advantage), but not vice versa. That is because if you attempt to change from Medicare Advantage to Medigap, carriers can deny your application, and it is their sole discretion. Further, you will have to wait until the Annual Election Period, because you cannot cancel a Medicare Advantage plan to enroll in Medigap during the middle of the year (unless you qualify for a Special Enrollment Period, described earlier). In short, you can see that this option to change would mean that Agreement 1 should be more expensive than Agreement 2. A buyer should be willing to pay for the right to change between the two configurations, all else equal.
The stunning decision made by many: paying more for Agreement 2 when compared to Agreement 1. Nevertheless, this happens in many locations, where the most expensive Medicare Advantage plan is selected, instead of Medigap. As you can see by this Addenda, this configuration contradicts the common-sense reasoning used here.