Monday, August 31, 2009

Covering Insurance

A podcast with FEE on this topic is found here.

If you have a television or have listened to talk radio you cannot help but notice the large controversy surrounding the role of government in our health care system. Recently I heard one talk radio caller make the following comment: “I can see that doctors and nurses provide a service, but what does an insurance company add?” The implication was that since insurance companies are not adding anything “real,” they are simply parasitical and could be easily replaced with a government agency.

Today there is a general lack of understanding when it comes to insurance. The word “insurance” has been misused for decades. We have Social Security Insurance, Unemployment Insurance, Medicare Insurance, but none of these programs are actually insurance programs. Many people look at insurance as a Club Membership Discount Card. The thinking is “Once I get the card, I will get health care for less or even for free!” However, this is not what insurance is.

Insurance is about the mitigation and elimination of risk.

It begins with the idea of class risk. Class risk means that we know the statistical probability of an event happening to an individual in a group but we don’t know who in particular it will happen to. So we could know that a certain percentage of MOC students will get into a car accident or get cancer or have their house burn down, but we couldn’t point to someone and say that it would happen to a particular person.

If an individual can influence the probability of the event, then they change their risk class. So if you are a careless driver, then you are a higher risk. And this is why we do not pay insurance claims to arsonists who burn down their own houses.

Insurance is when we all put a small amount of money into a common pot. The winner of the pot is the one who suffers the tragedy. So the guy who gets into a car accident is the winner and gets to pull the money out of the pot. The guy who gets cancer is the winner and the winner is also the guy whose house burns down. The losers are those who are fine. They are not in car accidents nor have any other tragedy befall them. The money the “losers” put into the pot goes to the “winners.” The risk of not being able to pay for the catastrophic event is reduced or eliminated because of the existence of this pool of money.

Suppose that you and your friends have no insurance and there is no social safety net. As a result, you are exposed to risk. If something happens, you are fully liable for the full cost of whatever that has befallen you. Suppose that you are most worried about broken bones. You and your friends are a fairly safe group and the class risk for this group is that one person in the group will break a bone over the course of the year. We don’t know who will break their bone this year but we can predict that it will be one person. So if you and your friends come together and each put a small amount into a fund, then the winner, the person who breaks a bone, gets to pull the money out of the pot to pay the doctor. The small amount that each person puts in is the premium.

Now suppose that another group, a bunch of rugby and lacrosse players, want to join your insurance club. They are of a much higher risk class. They are much more likely to break more bones than anyone in your group.

If they are able to join and pay the same amount as you and your friends, then they will be subsidized by the “losers” of the club. The rugby players will pull money out of the pot at a much faster rate than before. So either the rate they pay will have to go up (because they are in a different risk class), or everyone’s rates will go up (thus transferring more wealth from the losers to the winners), or once the money in the fund is used up, that’s it, and no one can pull money from the pot.

We have moved away from using insurance according to the first choice. Instead, we have been raising rates across the board or have started to ration health care. A few years ago, Massachusetts created a law that requires all people to have medical insurance. Today 95% of the state’s population is covered. The result is that health care gets overused and healthcare gets rationed. The average wait time in the top 15 metro markets for a specialist is 20.5 days. However in Boston it is 49.6 days. (The next highest is Philadelphia with 27.0 days.) This result is even more surprising when it is discovered that Massachusetts has the highest number of doctors per capita in the nation. Rationing means longer waiting times. The waiting times in Canada and the U.K. have become ridiculous.

We have come to look at medical insurance as a discount card or entitlement. It is not surprising that people will use more health care services if they are not directly paying for it. If the funds come from a third-party payer, then why not run that extra test just to be sure or go to the emergency room and see the most expensive doctor? If someone else is footing the bill, then why should I be concerned with how much it costs? And if I do care, can I even find out?

If we decouple insurance from the idea of a free give away or entitlement and return to the idea of risk mitigation, the health care landscape would change for the better. Individuals would be able to buy insurance according to their own needs. If I am worried about broken bones and car accidents but not sickle-cell anemia, then I could get an insurance plan that covers me the way I desire.

Regular doctors visits are not something that insurance should cover because there is no risk to mitigate. As a result the responsibility of buying health services is placed back on to the customer. Consumers are better with spending their money than any bureaucracy. There is no grocery store insurance or clothing insurance and we see that these prices are competitive. And there is a diversity in the markets. On one end of the spectrum there are stores such as Whole Foods and Nordstrom and on the other there are Food Lion and Walmart. And just because you occasionally shop at Nordstrom doesn’t mean you can’t pick up some socks from Walmart.

Today if one has a preexisting condition, he cannot get insurance. Or if he can, it is extremely expensive. Why? It is because we do not have a free market in health care. There is blanket coverage in policies that are organized through employers. (Using employees of a firm doesn’t even make any sense normally. Why would a single firm’s employees all belong to the same risk class for broken bones, etc.? Yet they are all under the same plan!)

Imagine a person who has won the fight against breast cancer. It’s true that the risk of cancer returning is higher than the risk to another person (thus a higher premium for cancer insurance), but why shouldn’t this safety conscious person be able to buy health insurance for broken bones at the same rate as those in your club? Obviously we live in a very skewed system.

A truly free market for health care would have a great diversity in options for all. With consumers spending their own dollars, costs would come down just as they are in the relatively free markets of cosmetic and lasik surgeries.

Insurance companies in a truly free market reduce and eliminate risk; the risk that you will be unable to cover the costs of a medical event. The losers are those that pay in and nothing happens to them. And while the insurance winners are those are able to collect from the pool of funds, in a truly free market for health insurance we are the winners with falling costs and increasing quality. If we turn away from the market and adopt a system that is controlled by bureaucrats and politicians we will all be losers.

A podcast with FEE is found here.


Nathan said...

Dr. Cwik, thanks for articulating the concept of risk class. I didn't know this term before, but I can definitely appreciate its timeliness in the discussion of insurance vs. entitlement programs. A 25-yo friend of mine was recently diagnosed with melanoma months after enrolling in her graduate school insurance program and was kicked off of her insurance b/c the cancer was a pre-existing condition. She felt that she was ripped off b/c there is some question as to what "pre-existing" reasonably means (previously detectable, previously existing in a strict sense, or what?). I don't know the details of the situation, but it raises the question of contract law. Why aren't insurance companies beholden (as they presumably would be under perfect competition) to the consumer for well-understood (to the consumer) insurance contracts?

P F Cwik said...

Nathan, you make a good point with regard to contract law. Truly, there is a need for clearer rules. However, instead of waiting for government to create those rules, a free market would do so more quickly and more efficiently. If there was actual competition between insurance agencies (which currently does not exist), then you would see the different insurance companies compete along those lines as well. E.g., "Buy our insurance, because we date any prior conditions to when you take your first physical with us... etc." Those policies may be more expensive because the insurer is taking on more risk. However, if we had government mandate that all preexisting conditions need to be covered, then ALL insurance policies would become more expensive. This is the wrong move to make when the focus on health care policy is to make insurance more affordable.

Nathan said...

I can appreciate your point. If I could just pursue this topic one step further; I was wondering if it seems reasonable to you to attribute most of the flaws in the current system, such as poor accountability for insurance companies (third-party payers as Dr. Orient calls them) and rising costs, to the conglomeration of employees from various risk classes into employer-offered health insurance policies. You mentioned this as a factor in your post. However, health care policy makers seem to be building health care "marketplace" policies around the employer with "pay-or-play" requirements and such. A professor from Oregon State who was teaching a class I took on health care policy (and shamelessly advocated single-payer, on the basis of a classical, Marshallian - I think - economic model of healthcare, without even blushing until I called him on his choice of model) was incredulous about the direct-payment option (i.e. getting rid of government-->employer-->insurer-->consumer health care tax subsidies) because health care costs too much for individuals. (He mentioned direct pay simply as a straw-man.) Where is all of this antipathy to direct-pay and disregard for the individual consumer coming from?? Why is the employer the focal point for all this reform? Is it the fixation on Walmart's health insurance policies coupled with our president's sympathy for unions? Is it a fundamental difference in assumptions, i.e. that one person cannot take care of himself, given the chance?

Dave said...

Absolutely brilliant analogy and explanation as to how actual insurance works. Social Security can't be insurance because everyone WILL retire. Retirement is not a risk, it's a given. Seems healthcare has become a given too, I guess.

I felt that as you closed your essay, the idea that a free market would fix the problems became muddled. The conservative radio boys suffer from this as well. They declare a free market will reduce costs, but they do not seem to know exactly what aspects of healthcare are "unfree" much less how to free them.

I think I know. Check me on this. And it speaks to your example that all the people who work for one firm are on the same health plan, i.e. the reason they're all on the same plan is the same reason the plan costs so much.

The reason is the tax free nature of health benefits. Actually that's the mechanism not the reason, like the symptom not the cause.

The average American worker receives $800 of their monthly income in the form of tax free health benefits (employee pays $400, employer "matches" it). Because of the tax exemption, that income cannot be spent on ANYTHING but healthcare. Consequently, healthcare does not have to compete with anything else in the economy for that $800. Does not compete with food, boats, housing, college education, cigarettes... not anything.

So how much is healthcare going to cost? $400 a month? The market is never stupid and the healthcare industry is no exception. They're going to charge what the market can bear... $800, duh.

This tax exemption is also the cause of, as you pointed out, everybody at one firm being covered by the same plan regardless of individual risk factor. The exemption puts the entire burden on the employer and therefor incentivizes him to pay as much in tax free benefits as possible under as few plans as possible; both being a cost savings to the employer, not the employee.

Once again, good intentions causing more problems than they fix.

The cause of healthcare costs being out of balance is the set-aside nature of healthcare benefit income. Currently the mechanism that creates this set-aside is the tax exemption of the benefits. Medical Savings accounts would do the same and solve nothing. The money would not be available for anything but healthcare.

As long as the tax exemption persists, healthcare will always cost about 110% of the average US healthcare plan. If that average cost rises to $2000 a month then healthcare costs will rise to meet it because that is what the customer is able to pay. And, as you point out, since the customer has already paid, they're sure going to use it... duh.

There are several approaches to the solution, but that's another topic. However, the solution would in fact bring back true health insurance.

This of course would not address the universal coverage issue, but it would eliminate the overwhelming cry for universal coverage in the first place, because virtually everybody would be able to buy health insurance.

Same kind of deal regarding the cries against capitalism. If capitalism wasn't so prone to using government to plunder it's customers, it wouldn't have such a bad rap, which is why I make a clear distinction between the free market and capitalism.


Dave Williams

P F Cwik said...

Nathan, "Where is all the antipathy coming?" is a great question. Unfortunately, I could only guess at an answer.

I can answer why there is a focus on employers. In World War II, the government placed wage and price controls on many jobs, goods, and services. In order to attract more employees during the war, firms would normally raise wages, but with the price controls, they started to offer non-wage benefits. Health insurance was one of the more popular non-wage benefit. Since most people worked for the same employer decade after decade, the risks were spread out over time. However, such a system is woefully backward in an economy where people change jobs every few years.

So politicians, who are always unable to think outside of any box, can only focus on employer provided insurance. All of the taxes center around it. All of the tax benefits center around coporate provision. So it should come as no surprise that policies are still centered on employer provided health insurance.

P F Cwik said...

Dave, you are absolutely correct that the government has its thumb on one side of the scales. It is allowing corporations the ability to write-off much of their health care expenses. This situation distorts the market as you describe it.

It is a complex issue and it needs a more complete understanding before we start to nationalize a sixth of the economy.

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