Tuesday, May 12, 2009

Why Health Insurance Doesn't Work Like Any Other

Why Health Insurance Doesn't Work Like Any Other

Despite the wreckage caused by the economic crisis, the Obama Administration is still focused on health care reform, and not without good reason: the sharp increase in personal insecurity, plus the reduction in debt headroom, have made health care reform increasing important. Today the President is calling in representatives of the health care industry to pledge to reduce costs voluntarily; tomorrow the Senate Finance Committee is discussing comprehensive health care reform.

As the debate begins, I wanted to touch on a couple of basic concepts.

The health care debate seems particularly hampered by confusion over labels. Uwe Reinhardt has a useful article describing different systems that focuses on how care is provided and how it is paid for. He distinguishes between: social insurance, where contributions are made on an ability-to-pay basis (taxes, for example); private insurance, where contributions are based on an individual's expected costs (more on that later); and no health insurance, where you pay the full cost of treatment.

I would go a step further and say that part of the confusion is over the terms "health care" and "health insurance." People who think there is a problem with the current system usually say that everyone should have "health insurance," and leave it at that. If pressed, they would probably say that this "insurance" should be provided by private-sector insurers (this is America, after all). I know something about insurance (I co-founded a company that makes software for property and casualty insurers), and I don't think this is makes sense.

The basic idea of insurance is that risks are shared across a pool of people so that each person is protected against unlikely events. In a free-market homeowner's insurance system, insurers charge premiums to each homeowner, and only make payments to the ones who have their houses burn down. (I'm simplifying for ease of exposition.) For this system to work, though, the insurer has to charge each person the expected cost of providing the insurance - that is, the value of his house times the likelihood of his house burning down. Most people would agree that this system is fair to homeowners, and usually affordable - if you can't afford the premium, don't buy such a big house.

The analog in health insurance, however, quickly becomes unsupportable. Unfortunately, sick people (and, to a lesser extent, old people) have much higher expected health care costs than young, healthy people. In an actuarially fair health care system, their annual premiums should equal their expected annual health care costs. For someone with a serious illness, those expected costs would easily dwarf his expected income. There is no way to "buy a smaller house." So in an actuarially fair, free market system, he would be unable to get health insurance, would be unable to afford health care, and would . . . die.

Put another way, from the perspective of the insurer, the rational thing to do is charge people more than their expected health care costs, and the efficient outcome is to not insure very sick people. When we say that anyone should be able to get health insurance, we are saying that someone should be forced to lose money insuring sick people.

Things are not quite so bleak in this country, yet, because we do not actually have a free-market health insurance system. We have government programs to step in and cover some people who cannot afford insurance. Large employers play an important role, because they have the bargaining power to force insurers to cover all of their employees at flat rates (rates based on the average health of those employees, not the health of each individual employee and his family); small businesses have no such luck, because if you have five employees and one becomes seriously ill, that will drive up premiums for all five. And we have emergency rooms at not-for-profit hospitals. But these are all band-aids that are becoming weaker and weaker, either because the government cannot afford its health care expenditures at their projected growth rates, or because the free market is chipping away at employer health insurance.

Actuarially fair health insurance is something that only works for healthy people. There are various ways to try to patch the system, such as making coverage portable and forcing insurers to ignore preexisting conditions when calculating premiums. Taken to its logical conclusion, though, that implies that you only have to get medically underwritten (evaluated by the insurer for healthiness) once - when you start working - and then you are safe for the rest of your life, because any illnesses you get will be covered as preexisting conditions. If that's the case, then, insurers will have to boost premiums for everyone since they can't charge differential premiums (unless they start evaluating your DNA when you are young, but let's ignore that problem for now), and then no one is ever paying premiums based on his health - and we have something very close to social insurance.

I can't foresee what the solution will be, because this is a fundamentally political problem. But the basic presumption that health care should be paid for via a health insurance system, in which insurers make money by charging premiums that exceed expected losses - and that's how insurers make money - is part of the problem.

--James Kwak

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