Health Insurance Exchanges 1: A Free Market Fable

As things look right now Wonks Anonymous is betting that we will get some sort of health policy reform in the next few months. Which form will no doubt be most moderate, something that our friends in the insurance industry can feel comfortable with. The most likely outcome here will be some sort of government managed and regulated market for health insurance like the Wyden-Bennett Healthy Americans Act.

Those who glaze over when reading legislation can see a reasonably clear explanation of the proposals written by Alain Enthoven in this Sunday's SF Comical. It works something like this:

A. Create a health insurance exchange: The federal government should create a system to offer standard benefit health insurance packages and impartial information about them so individuals could choose what best fits their needs.

The system, or exchange, would make it easy to compare the plans.Employers would contribute fixed dollar amounts not to exceed the priceof the lowest-priced plan in each market. Employees would choose theirown plan.

All insured employed people would be eligible to participate,regardless of pre-existing conditions, and would be able to keep theplan even if they changed jobs.

The exchange would collect money from plans who enrolled the healthiest to compensate those enrolling people with health problems,so no plan would have an incentive to avoid enrolling the sick. Twof orces would make this exchange work: People would save money by choosing wisely, and health plans would be motivated to keep costs down to attract customers.

Now there is a lot packed into these short paragraphs, enough for several blog posts or maybe a week of micro classes, so Wonks Anonymous will take this one slowly, starting with the material in boldface.

Health Insurance Exchanges are a substitute for something that does not naturally occur with health insurance. A functioning, informative market that is open to all on the same terms. The idea here is to get rid of deceptive marketing strategies and explicit exclusion of sick people, make an effort of evaluate plans and inform consumers and then push the restart button and see if the outcomes will be better than they have been. A nice idea and worth exploring for a number of reasons. If only because it is a good exercise in thinking about how markets really work.

So lets make the heroic assumptions:

  1. Exchanges are in place and consumers have uniform good information about the policies offered on the exchange.
  2. Private, for profit, insurers participate in the exchange. Call them MegaHealth. They are dedicated to making the most money possible from the insured.
  3. An alternative, cooperative health insurance plan is founded with adequate federal seed money to compete with MegaHealth. Mother Teresa Memorial Health is dedicated to providing comprehensive health insurance at the lowest possible cost to as many people as possible.
  4. Insurers must accept all applicants and they must charge the same premium to all applicants who purchase a particular policy.
  5. Insurers must at least break even. Premiums must cover medical costs of policyholders and administrative expenses.
Initially MTMH is highly competitive. Its operations are about as efficient as Medicare and that gives it a 9% cost advantage. People also like comprehensive coverage with low out of pocket payments and deductibles.

The MegaHealth companies are worried until a traveling consultant makes a suggestion for a new generation of health plans. Golden Youth plans are not nearly as comprehensive as standard insurance. A high deductible - say $5,000 - must be met before the insurance companies pay for any medical services and, after the deductible is met, substantial payments may still be expected. Why would anybody buy such a plan?

Because Golden Youth Plans are cheap. They are cheap to administer and can be sold at low prices. The thing is that most people - 75% of the population - never get to the $5,000 deductible. The money comes in from these folks and it never goes out. They feel better because they have health insurance. The advertisements and glossy brochures enhance their belief that they are too youthful, too athletic and too smart to get sick.

And, even when MegaHealth has the misfortune to insure some unattractive sick person, losses are limited. The deductible and co-insurance still place most of the risk of payments on the insured and his or her health care providers.

Because Golden Youth plans are so cheap and shiny the only people who avoid them are old, unattractive sick people.

Without discrimination or medical underwriting people sort themselves voluntarily
into the good customers and the sick ones.

Enter adverse selection. Mother Teresa finds that young and healthy people are canceling their comprehensive policies and going over to MegaHealth. Because the average cost of administering a health plan depends on the average health of the plan members. As the population insured by Mother Teresa becomes older and sicker, costs rise. Mother Teresa is forced to raise premiums in order to break even. Meanwhile MegaHealth sees its costs drop because its customers are healthier on average.

Of course the comprehensive policy becomes even less attractive to the young and healthy as cost rise. We are in a vicious circle which can end in two ways:

Mother Teresa goes out of business or offers its own line of Golden Youth policies. Which means that people buying health insurance on the exchange have one choice: a plan which requires that they pay most medical expenditures out of pocket and pay a premium for the privilege of having some insurance against major medical disasters. Consumers buy insurance to help them to deal with financial risks caused by illness. At the same time consumers bear most of the financial risk of illness.

Mother Teresa continues to offer expensive comprehensive plans.
Unattractive old people buy these plans because, although they are expensive, it is better to pay for medical disasters in moderately large monthly installments rather than be bankrupted by sudden onset of high medical bills.

In this situation there is one satisfied group, the beautiful, athletic and intelligent golden youth pay low rates and never really have to confront the fact that they couldn't find $5,000 to pay the doctor should they fall ill or get into an accident. When illness or injury does cast them out of the Neverland they may feel some shock as they actually meet their deductible face to face. They will probably also feel some regret when they find that they cannot buy a decent cheap comprehensive policy like the policies that Mother Teresa used to offer when they were kids.

Please note that this all happens under strict government supervision in a situation where there is no explicit discrimination. All that is required is a simple variation in benefits to trigger a market failure.


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  • 8/19/2009 6:08 AM kathie biddle wrote:
    This is exactly what has happened in the auto insurance field. All risks have been dumped into the high-risk pool, which has driven rates there to prohibitive levels.

    Yeah and you can do more about your driving.


    Reply to this
  • 10/31/2009 5:36 AM Russ Christman wrote:
    OK. So what happens with no choice fixed benefits (perhaps middle of the road) pathway? Thanks for thinking. Best, RUSS
    Reply to this
  • 11/19/2009 8:29 AM eRobin wrote:
    What about risk adjustment?

    If you risk adjust based on the cost of a consumer to the HDHP/Golden Youth Plan you do not pay for the full cost of high risk consumers to the comprehensive plan.

    Effectively you encourage the HDHP plan, which is exactly what Ron Wyden wants to do. His idea here is that by putting people at risk of a substantial portion of their income in the event of illness you will encourage them to save money by not seeing doctors until things get desperate.

    Wonks Anonymous thinks that this might be fine for Senators who are usually millionaires. He thinks that the health of the poor will suffer.


    Reply to this
    1. 1/20/2010 11:33 AM Tony wrote:
      Exactly. Risk adjustment is how auto insurance works to keep costs low, but HDHP remains profitable using another strategy - passing the deductible costs on and usin premiums for the high risk health plans.

      My main concern is that shopping for health insurance will never be a free market, which WA gets at above. You think shopping for car insurance is painful? You have to choose a premium, deductible, coverage max. Health insurance can take so many forms it's hilarious - HDHPs, PPOs, HMOs, EPOs/POSs (which are just blends of HMOs and PPOs), Health Savings Accounts, Indemnity Plans for the truly sick, etc. They all work differently. In addition, besides worrying about premiums, deductibles, and copays, you have to worry about what services they cover/don't cover, in what amounts (percentages? flat rates?), what drugs they'll pay for, and whether or not they'll deny your claim in the end. Pre-existing conditions are another worry that Obama plans to get rid of, but in the face of those, there are millions of people who will never be able to get an individual insurance plan.

      How can consumers make informed decisions on healthcare when you see everyday people gravitate toward limited health plans that will screw them in the end (a la MegaHealth)?
      Reply to this
  • 12/14/2009 10:06 AM rebecca czinner wrote:
    The end result would basically be exactly what we have now! Some people will pay high premiums for coverage and some people will not have proper coverage. The best idea is to have Congress on Medicaid, NOT their platinum coverage.

    Medicaid is far too kind. I would suggest a special exemption for congress critters that makes their deductible 200% of the ordinary limit and taxes their premiums at 50%.

     - WA

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