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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 increasingly 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 among 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 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

By James Kwak  |  May 11, 2009; 10:22 AM ET
Categories:  Health care  
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Germany arguably has the best health system in the world (which is inarguably better than the US health care system) and it does so through a mix of private and public insurance.

If you gents want to keep us as informed on health care as you did on the financial crisis, you better move quickly beyond the US, Canada and UK examples... these are the worst systems in the OECD... and it's no coincidence people on the Right use them for comparisons.

Posted by: Norcim133 | May 11, 2009 2:53 PM | Report abuse

good article. please provide more substantive articles (like this one) from people without a financial interest in the outcome.

Posted by: PindarPushkin | May 11, 2009 4:33 PM | Report abuse

I agree with Norcim133. Health care systems exist already in a number of European countries that far surpass our own in overall quality, efficiency, and humaneness. (My experience of being successfully treated in Austria for advanced throat cancer helped me appreciate what this can mean personally.) Why not study and emulate the good things that others have achieved?

American medicine remains the envy of the world. But while we excel at the art & science of medicine, the business side of it has run amok, putting medical skill out of reach of too many people. Thanks for your lucid explanation of the insurance aspect.

A propos, I don't understand today's pledge by major players in the health care industry to reduce costs by $2 trillion over the next 10 years. If they were competing in a free (or mostly free) market, how could they possibly make such a commitment? And if they can make such a concession in order to preserve something like the present market structure, what's to prevent them from reverting to their old ways at the first opportunity?

Are the vested interests coping with health care reform by adopting a strategy of "love it to death"?

Posted by: Hernalser | May 11, 2009 8:05 PM | Report abuse

Hernalser had identified a critical flaw in the Government's (read administration and Congress) position: How can we possibly expect the for-profit health care industry to actually provide cost-effective health care without seeking to game the system the way they've always done. As a retired doc, I can attest that the incentive to make the most personal gain on the part of providers, insurers, etc is enormous. Only a rational, single payer national health program has a ghost of a chance to do what our fearless leaders claim they seek. To actually believe the insurers when they say they seek to provide insurance to everyone and to reduce the rate of increase of health care while continuing to make profits for their shareholders is equivalent to believing in the Tooth Fairy.

Posted by: dbroder1 | May 11, 2009 8:53 PM | Report abuse

Health care reform in the US will fail unless "fee for service" is abolished. That won't happen because the AMA (the doctor's union) controls the price of health care via it's tight grip on the Medicare fee structure. The AMA is the most powerful union in the world; and American lawmakers will not fight it.

Posted by: booke | May 11, 2009 10:41 PM | Report abuse

Kwak says “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.”

And of course he will die, so will we all, but one of the reasons he cannot afford health care is also that he is not allowed to fully capitalize the societal value of his unhealthiness by for instance having to pay less in social security as he is actuarially expected to live shorter.

We are touching here on some fundamental issues and that are also very closely inversely related finance as for instance when some opaque credit scoring is used to trick some who should actually be paying lower rates into paying higher rates just in order to compensate for those who won´t pay within his supposed risk bracket.

Do you know that when turning a fix amount into an annuity in England you can actually negotiate a higher payment if you are a smoker? As far as I know there is nothing of that sort in the more limited US free market.

Posted by: PerKurowski | May 11, 2009 11:04 PM | Report abuse

The term "private health insurance" is a sham. Ultimately insured people pay higher rates because the uninsured have few alternatives to the emergency room when medical care or hospitalization is urgently needed. Hospitals charge higher for all in order to cover these expenses so insurance companies charge higher rates for the insured. A few trips to the emergency room cost more than regular trips to doctors. In addition, to the cost per visit, people generally are sicker by the time they go an ER, incurring additional expense.

Bottom line, the insurance rates of the insured already are padded to subsidize the costly but inadequate medical care received by the uninsurable & those who can't afford insurance. The piecemeal approach James Kwak described helps obscure the true cost incurred on the system as a whole when people are refused insurance.

Posted by: aimzzz1 | May 12, 2009 9:35 AM | Report abuse

"The basic idea of insurance is that...each person is protected against unlikely events...The analog in health insurance, however, quickly becomes unsupportable."

It's about damn time that someone pointed this out. In fact, the disconnect is even worse than presented here. The vast majority of health care costs come at the end of life (this was true in the 90s and I doubt this has changed), and "end of life" is decidedly NOT an "unlikely event" - indeed it's 100% likely.

That plus the continued progress of medical innovation inevitably means that any universal public health care scheme must be rationed - a politically difficult proposition.

Universal health care is a classic case of market failure. Markets are great for what they do, but they can't solve everything and we need to stop pretending that they can.

Posted by: ami49 | May 12, 2009 1:50 PM | Report abuse

Your point about why health insurance is different from other types of insurance is well-taken and points out why simply free market policies don't work. I would like to see this administration set up a national health care system based on that provided for federal employees - including the Congress. This system already extends across the country. I want all doctors/hospitals/clinics and every other type of provider to be required to participate. I want the premiums/payments set as they are in the federal employees'system. Then, if a person has employer-based health care, if the premiums the employer/employee pay are equal to, or more than those of the national system, the employee has the choice to join the national system with the employer/employee sending their premiums in to the national provider up to the cost of the federal employee/government premiums. Individuals would be able to buy in, with subsidies if necessary based on income - or call it a tax deduction if it gets more support that way. This way all the efficiencies discussed by the administration can be implemented immediately. Cost containment and standardized care based on best practices will be far easier to implement. No-one would be denied coverage. One could go to any doctor/other service provider they chose. And when changing jobs, the coverage can go with you with the new employer picking up premiums if they provide insurance as outlined above, or the individual picking up the total premium with subsidy/tax break as necessary. Anyone who wants to keep their employer's insurance company is welcome to do so. Anyone wishing to purchase individual coverage from a for-profit insurance company is welcome to do so. Medicaid and Medicare can be folded into the national plan with set - and equitable - contributions from states to the national plan replacing the current payment system. Potential universal coverage with no geographical, provider or pre-existing condition restrictions; rational, evidenced based care; national data bank; what more could you want? I'd pick the national plan in a heartbeat. And if employers just drop all health insurance coverage, they can be assessed a standard fee based on number of employees/size of business - and so can the employees. And, again, subsidy/tax break as needed. Just please don't leave things the way they are, because then the problem of out-of-control costs will just get worse.

Posted by: belindavet | May 12, 2009 9:54 PM | Report abuse

Well as part of our exmination of health care I think we need to look carefully at the issue of immigrants(legal and illegal), refugees, and other foreigners. Why should the US taxpayer pay for an kidney transplant for an illegal alien? Shouldn't we compel the government of Mexico to pay? If a foreign visitor falls ill, shouldn't we demand that they pay for health care or that their government do so? Why should we admit refugees from Third World countries who are bringin Third World diseases - like Changas, malaria, Cholera, leprosy?

In a sense we have immigration polcies which increase illness in this country -- shouldn't we start cutting back on these policies and examine more closely the health of those we admit to this country. Granted it is only a drop in the bucket, but we have to start somewhere and using the ER as your primary care is not a health policy and we need to inquire more closely into those who do.

Posted by: Lavrat2000 | May 13, 2009 12:42 PM | Report abuse

The essence of insurance is EXCLUSION and the value added of an insurance company is in how well it does this. Avoid the risks that are likely to result in claims -thereby you can charge less and make more money. This works very well in say auto insurance - who would argue with the notion that a reckless driver should pay more or be denied coverage.

However, that underlying premise just doesn't work in health insurance. The latest scam put forward under the guise of "reform" is to require (a)everybody to buy insurance (b) cover everybody including pre-existing conditions. Sounds great whats not to like? Except for one little problem- what exactly are the insurance companies doing to earn their profit? The insurance companies don't have to underwrite nor do they have to market since courtesy of the government they have a captive market. For all that effort their shareholders get to make a 20% return on their money.

Beware of Wyden /Bennett bill that pushes this hoax and was endorsed by none other than George Will this Sunday.

Posted by: rds7481 | May 14, 2009 2:19 PM | Report abuse

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