How something you might not know costs you thousands, and what you can do about it

By William Cowie

Published: Wednesday, Feb. 12 2014 4:33 p.m. MST

In a nutshell, agency theory states that when a principal hires an agent, the agent is supposed to act in the best interests of the principal. However, despite being compensated in accordance with the principal’s interests, agents will pursue their own best interests, even at the expense of the principal compensating them.

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Editor's note: This article originally ran on Five Cent Nickel. It has been reprinted here with permission.

We live in a complex world where many things happen around us that we’re at a loss to understand or explain. High CEO compensation, soaring health care costs, a biased media and politicians being bribed are but a few of the things we see wrong with the world. Those (and other) problems have their root in a single trait of human nature. The study of that trait is called agency theory.

In a nutshell, agency theory states that when a principal hires an agent, the agent is supposed to act in the best interests of the principal. However, despite being compensated in accordance with the principal’s interests, agents will pursue their own best interests, even at the expense of the principal compensating them. That may sound abstract and ivory-tower irrelevant to your daily life, but it isn’t. It affects your pocketbook, directly and often.

Health insurance

Take health insurance. The insurer collects premiums from millions of people and becomes the gatekeeper for your medical expenses. Doctors, pharmacies and hospitals all have to submit their claims to the insurance companies for payment. You would think those insurance companies’ interests would be aligned with yours and the other policyholders: The less they pay out in claims, the more money they keep. You would think that they contest claims and negotiate them down to the lowest possible number to save everybody money.

You would be wrong. Their incentives work in exactly the opposite way. It didn’t start out like that, though. In the beginning, it worked as planned: Insurance companies predicted what claims would be and set their premiums a little above that (let’s say 30 percent) in order to cover their expenses and leave them a little profit.

It took only one bad year for insurers to discover something nobody thought of. Claims, despite their best efforts, happened to be higher one year than expected. That, as you can imagine, ate into the allowance they had set up to cover their costs. The outcome? No profits, no bonuses, no raises, no budget to hire help to process extra claims.

So, the following year, they told their employer clients, “Look, guys, we lost our shirts last year. We have no choice but to increase our rates across the board. You’ll see everyone’s doing the same.” Employers looked around and, sure enough, all insurers were upping their rates.

The insurance companies’ “30 percent” increased the following year on the backs of the higher premiums. Then there was enough in the budget for help, raises and bonuses, especially at the top level. However, halfway through the year, the brass discovered claims were dropping again. They faced a tough choice.

They could:

  • Lower their premiums the following year (They couldn’t very well go back to their clients and say, “Hey, guys, claims were down, but we’re going to keep raising your premiums.”)
  • With much shoulder-shrugging and crimped mouth corners, explain that claims went up yet again, necessitating another round of premium increases. But, of course, claims would need to actually have gone up for them to do that. Hmmm … what to do?
Then someone came up with a brain wave: If you lay off half the claims processors as part of “prudent cost control,” that would impair their ability to contest every claim, which would “accidentally” allow more questionable claims to slip through.

If they followed the first course of action, their 30 percent would go down. That would mean no raises or bonuses. However, if they were forced to show the clients an increase in claims, then their 30 percent would grow the following year. Saving cost (by laying off part of their workforce) and raising next year’s 30 percent — Can you spell “no-brainer”?

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