Health Care – Insurance 101

 

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Balancing Risk for Health Insurance

Given the recurring debate over a private market vs. a single (government) payer for health insurance, I thought it might be helpful to review a few basics of the insurance business. What follows borrows from an essay by Frank J. Lysy, a retired economist at the World Bank.

What is insurance?

Well, duh … an insurance policy is a contractual agreement in which you (the insured) make regular payments. In return, you get the insurer’s promise to protect you against claims associated with events explicitly enumerated in the policy.

As with all contracts, you do need to read the fine print.

How does insurance work?  

An insurance company has to manage premium income so that it has enough cash to pay claims as they come due. While an insurer cannot predict the claims profile of a single policyholder, a “pool” of policyholders typically has identifiable claim characteristics based on things such as age (drivers under 25), location (urban vs. rural), or health factors (smoker vs. non-smoker).

If the pool reflects a statistically “normal” population, the insurer can estimate expected claims with a high degree of confidence, and set a premium rate that will generate funds sufficient to cover those claims. If, however, the pool does not reflect the population as a whole, the insurer will find it difficult to match the actual level of claims and the premium income.

Ensuring that premium income generates enough income to cover future claims is the primary management task for an insurance company, whether it’s in the auto, homeowner or health care business.  However, it is a particularly daunting challenging for health insurance.

The Health Insurance Company’s Perspective – Adverse Selection

You, the policyholder, typically know more about your health situation than your insurance company.  If you have a family history of heart disease or cancer, you’ll probably want health insurance. By contrast, if your budget is strained or you are a healthy young adult, you may opt to forego health insurance.

Another problem is “free riders” that buy health insurance only when they expect to have a significant medical expense (e.g., a planned knee replacement).  As recently seen with the “Special Enrollment Periods” (SEP’s) under the Accountable Care Act (ACA), the pool of individuals who enrolled during an SEP had significantly higher-than-average health care costs; many let their policy lapse once their medical bills were paid.

This adverse selection means the pool will have a higher-than-normal percentage of individuals with higher-than-average claims. In this situation, a premium rate that would cover claims for a statistically normal pool of individuals will not be adequate to cover actual claims. To compensate, the insurance company can raise rates in the next premium period. Unfortunately, the now higher rate may lead some policyholders—typically those at low risk of medical expenses—to drop their insurance, causing the pool to develop an even more adverse profile.

Your PerspectiveBiased Selection

Health insurance companies, of necessity, try to bring the pool closer to a normal profile by enrolling policyholders who have lower-than-average claims.

For years, they accomplished this by denying coverage if you had a pre-existing medical condition. With the ACA, that’s no longer an option. But they can still build in criteria (check that fine print!) that allow them to deny claims you thought were covered, or to impose higher co-pays on certain types of expenses. For example, you might find that your surgeon’s fee is covered but the anesthesiologist’s fee is not. Or that drugs with a reasonable co-pay are “reclassified” into a tier with a substantially higher co-pay.

These unexpected costs can be financially devastating.  A Harvard Medical School study found that 62% of personal bankruptcies in 2007 in the U.S. were caused by medical problems; 78% of those filing for medical bankruptcy had health  insurance at the start of their illness.

Another angle to encourage people with higher-than-average medical expenses to enroll in a different company’s health plan. A classic example is adding the cost of gym membership to the insurance premium. This can deter anyone not interested belonging to a gym, but appeals to someone who is already paying for it.  This strategy improves the profile of the pool because people who go to gyms are generally healthier than the overall population.

What About The Individual Mandate in the ACA?

These two problems—adverse selection and biased selection—explain why the ACA requires every American to have health insurance. If everyone is insured, there are no free riders.  You can’t game the insurance company by waiting to purchase insurance until you know your medical expenses will be high. And if everyone has to have health insurance, insurers can be more confident of having a normal claims profile. Their incentive to discourage higher-than-average claimants is offset by the larger pool of lower-than-average claimants.

The Bottom Line

My point is that, from a purely financial perspective, it doesn’t much matter whether the system for health insurance is based on a marketplace of private companies (the ACA) or a single payer (Medicare)—as long as there is universal participation. Phrased differently, neither the private health insurance market nor the single payer system will be viable in the long run without something approximating universal coverage.

There is little doubt that the ACA needs to be fixed to reduce the problems of adverse or biased selection. But when you hear a politician telling you that everything would be fine if only all health insurance was private or if we only had a single payer system, take it with a grain of salt.  You’re probably hearing an argument based on philosophy, ideology, or politics…not basic principles of economics or finance.

Comments

  1. Linda Goeldner says:

    Absolutely agree there needs to be universal participation in the health insurance pool. The US system is so crazy because the main way to access an affordable pool of insureds is to have a large employer provide the coveage as a benefit of employment. That worked for awhile but it did little for small businesses and self-employed and those who could not work full-time, but hadn’t reached retirement age.

    US insurance premiums used to be based on community ratings where all individuals were put in the same pool, until the 1980’s when employers only wanted to pay for their own employees; so there was a big shift to “experience” rating. Again, if you are an employee of a medium or large employer, this worked fine; but it was awful for self-employed, small business owner or semi-retired. The ACA helped correct this marketplace bias; but it has to be done by covering everyone. Emergency rooms have to take everyone and they are the most expensive setting to receive care. This caused a purposeful determination of increasing health care costs which employers and all people objected to. Now that we have had the ACA for several years and people are getting preventive treatment in lower cost delivery setting, health care costs are stablilizing. The current driver of increasing health care costs are from pharmaceutical companies that are raising the costs on certain drugs by an unreasonable increase. Those pharmaceutical CEO decisions are raising costs, but some political groups still want to blame the assurance of covering all people for health care services. If everyone needs preventive care and treatment over their lifespan, then everyone should pay into a system.

    • Mary Gottschalk says:

      Linda … thanks so much for that lesson on how we got from the “major medical” that I remember as a kid to the goofy system where employers with a 100 people ended up with a risk-based pool where premiums changed dramatically from one year to the next, depending on age and known health conditions of the staff. It’s grossly unfair … and my next blog will point that Walter Reuther (head of UAW) thought so too.

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