8 Understanding Health Insurance

Reports that former Sen. Tom Daschle will be appointed Secretary of Health and Human Services suggest that reform of the U.S. health insurance system will be an early priority of the next administration.

If so, then over the next six months, we should expect vigorous debate about the direction any such reform should take. Past debates on the topic have largely ignored a fundamental difference between individual and pooled coverage. Pundits and politicians often discuss the two approaches as if they are interchangeable. From an insurer’s perspective, however, they are profoundly different.

In an individual policy, the insured's financial health risks are transferred to the insurer. This has three major cost implications. First, insurers must charge a premium for assuming the risk, based on its probability and size. Second, before issuing an individual policy, the insurer must assess the risk it is assuming. Finally, the insurer must thereafter manage its risk – for example, by terminating ill policyholders, as some insurers have been doing here in California.

Individual policy premiums must cover these costs. If the insurer’s risk assessment is accurate, each policyholder's rates should reflect his or her individual financial health risks plus the costs of assessing and managing those risks; individual coverage should not ultimately shift costs among policyholders.

In pooled coverage, by contrast, financial health risks are shared among members of the pool. If the pool is large enough, the insurer bears very little of the risk. In consequence, competitive insurers should not charge significant risk premiums, no risk assessment costs should be incurred before a new member can be admitted, and risk management costs should be low. As a result, the costs of pooled coverage should, on average, be substantially lower than the costs of individual coverage.

Case in point: I am currently paying premiums on an individual policy for my healthy 23-year-old daughter. The monthly premiums for her individual policy are higher than those for the pooled coverage of all of the rest of my family put together – two 50-somethings and two risk-taking 6-year-olds. Same company. Identical coverage. Higher individual policy premiums for one healthy individual than for pooled coverage of four beneficiaries of mixed health.

Pooled coverage provides these cost benefits only if admission to the pool is not elective. Typically, we become eligible for employer-provided health insurance if and only if we work for that company. We can’t just opt in or out at will. Similarly, we become eligible for Medicare by getting older. The more elective admission to a pool becomes, the more the insurer must intervene to manage its risks and charge a premium for those risks.

So what does all this mean?

First, all else being equal, pooled coverage should always be cheaper than individual coverage. The non-health care costs of Medicare, for example, are only 3 percent, while the non-health care costs of private health insurance run between 30 percent and 35 percent.

This is not because government is more efficient. It's rather because private health insurers must charge risk premiums and recover risk assessment and management costs – no portion of which amounts go to pay for actual health care. Medicare avoids these costs simply by reason of the fact it provides the ultimate in pooled coverage.

In other words, because of the risk premium, assessment and management problem, it is inherently impossible to provide individual coverage at costs comparable to pooled coverage.

Second, because elective admission to a pool effectively converts pooled into individual coverage from an insurer’s perspective, free markets operating at the individual level cannot provide pooled coverage. If we give each individual $5,000, as Sen. McCain proposed to do, and let them comparison shop, competitive insurers will still have to charge risk premiums and recover their risk assessment and management costs.

In other words, unlike markets for spaghetti, jeans, or apartments, health insurance markets cannot find the lowest cost solution without government intervention.

The U.S. solution has been to create an $80 billion per year tax subsidy for employer-provided pooled coverage, Medicare pooled coverage directly for seniors, individual coverage for others who can afford it, and a hodgepodge of backup solutions (like emergency room care) for everyone else. The European solution, for the most part, has been to offer pooled coverage directly to everyone.

Because of the inherent cost advantages of pooled coverage, we should expect the European solution to be substantially cheaper for the same level of coverage. And indeed, on average Europeans pay a substantially lower percentage of GDP for a much higher level of coverage.

American conservatives are tempted to call this “socialism”, and I suspect we’ll hear that accusation a lot in the coming months. I like markets. If free markets could provide equivalent value more cheaply and efficiently, I might echo the conservative critique. But they can’t.

Any cost-effective proposal, therefore, is going to have to look more like Medicare than the competitive market in individual policies Sen. McCain was advocating during the recent presidential campaign.

This does not mean that any such proposal will need to limit a patient’s choice of doctors. Indeed, were I designing a new health care system, my sales slogan would probably be something like: “We pay, you choose.” Pooled coverage can be fully consistent with patient choice.

But to take advantage of the inherent cost benefits of pooled coverage, any such proposal will have to be mandatory and effectively universal. It may rely on a mix of government and employer funding. It may ask insurers to compete to insure mandatory pools at the lowest possible cost.

But it won’t look anything like the classic unregulated market.

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If free markets could provide equivalent value more cheaply and efficiently, I might echo the conservative critique. But they can’t.