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Source: Vic, Flickr.

Health insurance is one of the most complicated things people have to deal with in their everyday lives. Given the rising cost of health care over the years, though, going without health insurance can be a ticket to financial disaster if you suffer an unexpected illness or injury. Because of the huge need for protection from high medical costs, the health insurance industry has drawn a lot of attention not just from policymakers seeking to make insurance more available and affordable, but also from investors looking for ways to profit from insurance companies that provide a product in high demand.

What is health insurance?

The idea behind health insurance is incredibly simple. Policyholders pay premiums in exchange for coverage of certain medical services, for which they have all or a portion of their related expenses paid by the insurance company. In effect, those policyholders who go through a given year without needing any medical care end up subsidizing other policyholders who need substantial care. Overall, though, the insurer providing the health insurance aims to keep total covered costs under its policies below the amount it collects in premiums, leaving enough left over to provide a respectable profit.

Health-insurance companies are regulated by the states in which they do business, with state insurance commissions generally putting restrictions on the ability of companies to set premium rates for their policyholders. At the same time, health insurers are also increasingly subject to the impact of reimbursement rates set by programs like Medicare and Medicaid, which make up a substantial portion of their overall coverage expenses, and therefore dramatically affect their profitability.

What is the history of the health insurance industry?

Health insurance first became available in the U.S. in the 19th century, but it focused exclusively on major accidents and injuries, and therefore resembled modern disability insurance. Although hospitals began offering prepaid health-services arrangements as early as the Great Depression, it wasn't until more recently that coverage for out-of-pocket health expenses became more widespread.

In many ways, the evolution of health insurance has taken it beyond the ordinary definition of insurance. Typically, people need insurance for events that are rare but highly costly, such as a car accident or the destruction of a home. By contrast, nearly everyone needs at least some health-care services, and so modern health insurance has more of a health-savings function than the usual catastrophic-loss prevention motive of more typical insurance policies.

How many health insurance companies are there?

If you look at a list of all the health insurance providers in the U.S., you'll find hundreds of different names. But when you look closely at the corporate structures of their parent companies, you'll find that most health insurance comes from one of just a few dozen health insurance giants.

What many people don't realize, though, is that employers often self-insure all or part of their health insurance exposure. Working with health insurance providers to manage costs, these employers seek to reduce their overall expenses and thereby save money. As a result, the thousands of employers offering health insurance effectively add to the total number of insurance-providing entities in the U.S. marketplace.

Why invest in health insurance companies?

Traditionally, insurance companies have made good conservative investments. Operating under the regulatory framework puts a limit on the amount of profit insurance companies are allowed to earn, but at the same time, regulation represents a barrier to entry for would-be competitors, and also allows at least a modest profit.

Moreover, many health insurance companies have gone beyond their traditional business lines to seek out more promising opportunities. Ancillary services such as pharmacy-benefit management and employee education give health insurance companies a chance to earn additional revenue in related areas while also controlling their costs and boosting their potential profit.

Health Insurance White House
Source: White House.

It's important to understand that not all health insurance companies are alike. Some insurers focus on providing services under government programs like Medicare and Medicaid. This has the benefit of ensuring payment, but it also comes subject to guidelines on things like maximum reimbursement rates. Large businesses also make good clients, with a broad mix of employees providing a reasonably large risk pool that can reduce the chance of unexpected losses. By contrast, individual policies can be comparatively risky, as all it takes is a single illness or injury to make any single individual policy massively unprofitable.

Overall, investing in health insurance during a time of reform carries some risks, but the opportunities for profit are still extensive. Looking more closely at how health insurance companies earn money will help you be a smarter policyholder, and it will give you valuable insight on investing in those companies.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.