Insurance: Share the risk
This is a guest post from Joanna Lahey, an associate professor of economics at the George H.W. Bush School of Government and Public Service at Texas A&M University and the National Bureau of Economic Research (NBER).
Ellen's note: Joanna has written four articles about health insurance. This is the first, and every Saturday for the next month, we'll be publishing one. Given the readers' concern over the cost of health insurance as well as the ability to get insurance, we think her articles will be a great addition to GRS.
What is Insurance?
We save for retirement in order to smooth our consumption over time. Money saved now when we have income allows us to eat more than cat food when we're retired and not bringing in as much.
Insurance works in much the same way, except instead of smoothing our consumption over time, we're smoothing it over conditions of the world. In the good state of the world, the one in which we haven't been hit by a bus, we spend money on insurance. In the bad state of the world, the one in which the bus hits us, the insurance company pays out money to help compensate us for our medical care.
People value this insurance because they are risk averse. For most people, losing money hurts us more than gaining the equivalent amount of money makes us happy. We're willing to pay a little extra during good times to offset the bad times.
Of course, in reality it's a little bit more complicated than that. Insurance companies have an incentive to keep you from getting into that bad state of the world, so they might pay for annual check-ups and other sorts of preventive care. Additionally, some people like the idea of using health insurance as a prepayment for expected medical expenses. However, preventive care and prepayment are not technically insurance even if they are bundled in with many policies. The point of insurance is to make the bad times less bad by paying for insurance during the good times and accepting a payout during the bad times.
In an ideal world, this insurance system would just work and the free market could handle everything. People would pay their expected cost of insurance into the insurance system and the insurance would pay out for the people who were unlucky enough to get hit by buses or have other health problems.
Unfortunately, there's a problem. People who know that they are likely to use medical care value insurance more than people who believe they will never get sick. The problem arises when people know their expected medical costs better than insurance companies do. This situation is called “asymmetric information” — one party (you) knows more than the other party (the insurance company) does.
Death Spiral in the Insurance Market
In this world of asymmetric information, there is theoretically no way for an insurance company to make a profit, or to even exist in the private market. If the insurance company sells insurance at the average cost of medical care — what it expects to pay out on average — then people who know deep down that they're healthy are going to prefer not to buy the insurance. People who know they are likely to get sick are more than willing to pay the average cost of medical care and sign up in droves. When that happens, the average cost of medical care that the insurance company sees goes up, so they have to charge higher rates for coverage. That means that the folks who expect to have ingrown toenails but no other health problems will drop coverage while the people who expect to get diabetes will stay on. That drives up the average cost of health insurance further, which means that the next healthiest group of people will stop buying coverage and only the most expensive stay on. Eventually only the most expensive person will be willing to buy insurance (and he or she probably won't be able to afford it). The market fails, and insurance cannot be offered. The private insurance market is broken.
Asymmetric information and this “lemons problem” (the term coined in an article by George Akerlof) are why it is so very difficult to get coverage on the private market and why the coverage is so expensive. It's also why private coverage deliberately doesn't cover conditions like pregnancy if it can legally choose not to.
Side note: You may have noticed that even though the private health insurance market is broken, it still exists. That's because of that risk aversion we talked about in the previous section — most people value insurance more than its expected cost. If they value it enough, they're willing to pay more and are able to get over the death spiral. Incidentally, David Cutler, one of the main architects of the Affordable Care Act, argues that the individual mandate is not needed — we just need to get the price low enough and risk aversion will get people to buy. Jon Gruber, another of the architects, disagrees — he doesn't think it is likely that risk aversion will overcome the adverse selection problem.
Why is Health Insurance in the U.S. Bundled With Employment?
The solution to the problem? Group markets for insurance. In a group market, people are in a group for some reason that has nothing to do with health insurance. Working for the same employer functions especially well because adults who work are healthier on average than adults who don't work. Everyone in the group is charged the same amount for insurance, and the average cost is low enough that the downward death spiral doesn't occur. The bigger the group, the more risk and costs are spread out and the happier the insurance company is. Large companies get cheaper insurance rates than smaller companies because it's less likely with a large company that the boss is getting insurance because he just found out his wife has cancer (and even if he did, that cost is spread out across more workers).
Doesn't that argue that we should have just one group for everybody? Well, yes. However, for historical reasons (price controls during WWII, as several folks pointed out in the comments of this Ask the Readers post), we ended up with our groups being attached to employment. That's fine if you're employed by a large firm that offers insurance (or married to someone who is), but makes things more difficult if you're not.
Why don't we just tear the system down and start from scratch? Well, it is difficult to destroy a private industry that is around 7 percent of our economy, especially when said industry has powerful lobbyists. It may be more efficient to have government-provided health insurance, but the costs of getting to that point would be large.
Given our current political and institutional situation, we can still get to universal health care even if single-payer insurance is unlikely. In the U.S. that means something like the Affordable Care Act, with its universal mandate, subsidies, and regulations prohibiting preexisting-condition exclusions or charging prices based on anything other than age and tobacco status. I will talk more about the basics of the Affordable Care Act in a future post.
How Much Insurance Should be Provided?
In the ideal world, insurance companies would provide full insurance. They would pay 100 percent of your medical care and maybe something to compensate you for pain and suffering. You'd have to pay a larger premium to get the insurance, but it would be worth it because if you got hit by a bus you wouldn't be out of pocket for anything. Unfortunately, this is not an ideal world and people are flawed.
- If you knew you were going to get compensated, you might be less careful about looking both ways before crossing the street.
- If going to the doctor is completely free, you might go in for a sniffle right away just to be on the safe side rather than waiting a few days.
- If someone else is paying, you might move to more expensive infertility treatments faster than if you have to pay the bill yourself.
- Your doctor might decide to do extra tests that only have a small chance of finding anything, because why not?
We call these changes in behavior caused by the program availability “moral hazard.” Moral hazard occurs when people do bad things they wouldn't have done if they were bearing the full cost of their actions.
Political economy side note: The trade-offs caused by moral hazard are one of the main points of disagreement between political parties. Public programs help deserving people who need help, but they can also cause people to do bad things in order to qualify for the public programs (through moral hazard). Programs that help children tend to be popular with politicians on both sides because children don't have moral hazard with respect to government programs — they're not the decision-makers.
In order to keep moral hazard down, it is optimal to provide less than full insurance. So insurance companies don't pay the full amount of every bill. That's why we have deductibles and co-payments and coinsurance.
Terms You Need to Know
Premium: The (usually monthly) amount that you pay to the insurance company to buy insurance. (Mine is $693/month for my dependents and me.)
Deductible: Some amount of money that you have to pay before the insurance starts paying anything. (Mine is $750.)
Co-payment: A flat dollar amount that you pay when you show up at the doctor (or the hospital) no matter how much your visit actually costs. (Mine is $35 for in-network and $45 for out-of-network.)
Coinsurance: After you reach your deductible, you may still be responsible for some of the costs. Coinsurance is a percent of the costs that you pay. (Mine is 30 Percent.)
Sometimes economists will group all three of these together: deductible, co-payment, and coinsurance under the umbrella term of “co-payment.” We do this because they're all ways of cost-sharing and thus reducing moral hazard. Living in Texas, I get all three types. The bill for my daughter's birth was $750 for the deductible, $35 co-payment for the doctor, and 30 percent coinsurance of $2,345 + $191 + $218 is $826 for my share of the rest (assuming that all of the bills have finally come in). So a total bill of $1,611.
That's a lot of information about the basics of health insurance. Next time I will talk about the pros and cons of different kinds of insurance you can get in the U.S. (PPO, HMO, HDHP, ACO).