Necessary But Not Sufficient

Wonks Anonymous has heard that the President was extremely persuasive in explaining the need for mandated universal health care coverage. He is glad of this because no health reform will work unless we have universal coverage - including coverage of the dread illegal aliens Mr. President.

It works like this: Suppose that we have a systems where health insurance is actuarially fair. The price of an individual insurance policy is equal to the average annual medical spending for the community. In the US right now we could call that $7,000 per year and not do too much violence to the facts.

Note that I assume no insurance company profits, they may exist but they are irrelevant for this argument.

Now the problem with voluntary insurance arises here. Each individual actually has a different probability of illness and therefore different expected medical spending. Given their condition, some people may expect to spend $10,000 while others only expect to spend $2,000. People will pay something to avoid uncertainty but it is unlikely that someone who expects to pay $2,000 will spend $7,000 to insure against a worse case scenario.

Because individuals have a decent estimate of their medical costs we will see healthier people opt out of the voluntary insurance system. As healthy people opt out, the average medical costs for the insured will increase. The price of insurance will have to rise to cover costs. As costs rise more people will find it to their advantage to opt out.

The only way to stop this is to force everyone to buy health insurance. This mandate is necessary for a functioning health insurance system. It is not sufficient as the following example shows:

Suppose that we have actuarially fair, mandated insurance priced at $7,000. Call this Plan A. At the same time we permit insurance companies to offer actuarially equivalent plans. An insurance company develops a plan with a $1,000 deductible. Call this Plan B. The deductible lowers the expected payout from Plan B by $1,000. Plan B can be sold for $6,000 per year.

People who expect to pay close to the average medical costs or more than the average medical costs will have no reason to switch to plan B. Their total expected costs will be $6,000 for the premium and $1,000 for the deductible as opposed to $7,000 for premiums.

People who expect to pay less than $1,000 in medical costs - and this would be more than 50% of the population according to the Kaiser Family Foundation - will have strong reasons to be attracted to Plan B. Their total expected costs will be $6,000 for premiums plus less than $1,000 for their expected payments toward the deductible. That would be less than the $7,000 premium for Plan A.

But the price of Plan A and Plan B will not remain the same. Without any active screening on the part of the insurance companies, consumers will self select for the two plans. Healthy people will move to Plan B leaving the less healthy in Plan A. As people move the price of Plan A will rise and the price of Plan B will fall.

Suppose the changes in the risk pool are enough to raise the average cost of Plan A by $500 and lower the average costs of Plan B by $500. Now Plan A will cost $7,500 and Plan B will cost $5,500.

Now with the possibility of paying a $1,000 deductible, people will have to be extremely averse to risk to choose Plan A. Plan B will dominate the market. This will have no huge public consequences.

At the same time, competitors on the insurance market will take the lessons taught by Plan B to heart. Someone will invent Plan C with a $2,000 deductible and people who do not expect to pay $2,000 in total medical costs will move from Plan B to Plan C. Plan C will tend to dominate Plan B and so on, as insurance companies take off their hats to reveal Plans D, E, F and G.

Ultimately we wind with up a few expensive, more or less comprehensive plans that will be patronized by the ill and the risk averse and some large, high deductible plans that attract the healthy and the deluded.

As deductibles become a substantial portion of consumer income this will have huge public consequences.
Very few families are really prepared to raise 20% to 25% of their annual income over the span of a few weeks or months so people with Plans D, E, F, and G often find themselves bankrupt or in debt on the event of a medical emergency.

The plans pay your medical expenses after a certain point but the uncovered portion is enough to leave you bankrupt. If the emergency leaves you with persistent health problems you will need to convert to an expensive comprehensive plan - probably assigned risk - or just get used to paying 20% of your income for health costs each year.

Not exactly the security that President Obama was talking about.


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