Why Health Insurance?

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“It can happen to anyone,” Obama said in his weekly address. “In the United States of America, no one should have to worry that they’ll go without health insurance — not for one year, not for one month, not for one day. And once I sign my health reform plan into law — they won’t.” — CNNMoney.com

According to President Obama, a health insurance crisis is upon us. He states in the New York Times that there are 46 million Americans who don’t have insurance, in some cases for as much as one day.

This exemplifies how the current debate about health care has turned into a debate about the insurance which will pay for the care, not on how people will obtain the care itself. Even on Mises.org, Dr. Robert Murphy devotes a considerable portion of his analysis to the problems with insurance. But that’s not the end of it. It is usually assumed without question that a fourth party (either the employer or government) will pay for the insurance premiums.

The most common ways that we pay for goods and services are cash out of current income, obtaining credit, or paying out of saved cash reserves. There are two parties in the transaction: the buyer and the seller. It makes sense for most of us to use insurance in a small number of purchases. The more common examples for individual and families are: residential property destruction, auto-related (liability for injury; theft), and accidental death or permanent disability.

But when it comes to health care, why is most of the discussion about ways to reform the current four-party system, not about reducing the number of parties involved from four to three or even two? Why is a cash-payment system direct from the patient to the provider not featured in most of the prominent reform plans?

I believe that the word insurance has come to mean the same thing as health care in the minds of most Americans. In the current climate of opinion, it goes without saying that a third party (know as an insurance company, but not really an insurer in the strict sense) should pay most health care expenses. The idea of cash payment — the way we pay for most services — is inconceivable. While the pathologies of the current health care system and possibilities for reform are a huge topic, I will attempt to address only a small corner of the issue: the preoccupation with three- and four-party payment systems.

First I will explain what insurance is, what it is not, why the insurance model only works for some purchases but not for others, and why most existing insurance plans are not really insurance.

Let’s look at the definition of insurance:

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating loss.

Only some future events are insurable. Insurable risks share certain characteristics: the risk of a single loss is small, the insured cannot cause the insurable event to occur, the magnitude of a potential loss would be too great for the insured to afford, and when the risk is spread over a large number of similar cases, the premium for each insured is affordable.

For market conditions to make insurance a sensible model, a risk must meet all of these characteristics. It would not make sense to obtain insurance against a certain expense — even it were possible — because the premium paid to the insurer would be equal, or greater than, the expense itself. Your house burning down is an insurable risk, while your car running out of gas or your pantry running out of grocery supplies are not.

Let’s segment health care expenses into insurable and non-insurable categories:

predictable care

annual physicals, teeth cleaning, a chronic but manageable condition, e.g. a medication or regular chiropractor visits, planned events such as giving birth

Not insurable

unpredictable non-serious care

minor injury, tooth cavity, a cut

Not worth the overhead to insure.

unpredictable but serious health emergencies

getting hit by a car, a life-threatening illness

Insurable

The first two of these categories are clearly not insurable because the risk of an event is close to 100%. In the second case, the cost does not warrant obtaining insurance. The third category is the best suited for the insurance model, presuming that the cost of obtaining care for an accident or illness is necessarily too great for an individual to afford.

One of the many bad side effects of the current system is that the meaning of the word insurance has become corrupted in public discourse. The way that the word is used in the current debate means, approximately, “a third-party payer who will provide unlimited health care at minimal or no cost to the patient.” I frequently hear people ask, “how can someone with an illness obtain insurance?” What the sick person needs is care, not (necessarily) insurance. In any case it would not make sense for an insurer to provide a policy to someone who is already sick.

When I blogged about this recently, I received several emails with questions along the lines of, "I have medical expenses that I cannot afford, therefore I need insurance." But insurance as such can only replace large unpredictable risks with small but known payments by distributing the small risk over a large pool of insured. Insurance cannot solve the problem of funding all routine or regular care because distributing a fixed and even expense does not reduce the cost — it probably increases the cost. A policy that covered predictable and recurring care would have to charge at least as much as the care itself, and then some to account for the overhead of claims processing. The insurance company must prevent fraud and ensure that the care they are paying for is necessary. This imposes additional monitoring costs. For the people who emailed me, a policy would only reduce costs if someone else paid the premium.

It is not necessarily the case that costs of care under a cash payment system would be the same as they are now. Under a cash payment system prices would have to be lower, for several reasons: people would become price-sensitive in their consumption decisions; third party monitoring costs would be eliminated in most cases; and providers would have to compete on the basis of price. See this discussion of health care in India for some insight into how a cash paying system might function.

While the current four-party system is not the only reason that costs are as high as they are, it is one reason. So we are stuck in a loop where costs are high because we have insurance but we must have insurance because costs are high. For more information about the history of the four-party system, I recommend the excellent paper The Modern Health Care Maze: Development and Effects of the Four-Party System by Kroncke and White.

Also, most people do not perceive the costs of the current system accurately. I believe that employer-provided plans are partly at fault for this. Because the plans are nominally paid for by the employer, they create an illusion that care is provided at no cost to the insured. Most employed workers do not understand that they pay for their health plan through reduced wages. The tax system is also partially responsible for this system because the employer’s expense is tax deductible, but the employee’s purchase of a similar plan out of their after-tax income is not.

People are for the most part unaware how much lower their wages are due to employer-provided plans. If your employer is providing a family plan that costs several hundred dollars per month, this is costing you thousands of dollars annually in lower wages. Having your employer purchase a policy on your behalf also creates the well-known issue of lack of portability when you change jobs. I wonder how many people do not change to a better-paying or otherwise more attractive job due to the portability issue.

Without benefits, the present employer costs would have to go back into wages. In my experience trying to explain this point, it is an unfamiliar concept and many people are skeptical. The most common response I get is that employers have the ability to simply lower wages by cutting benefits without increasing the cash component of wages, as if the level of wages is totally discretionary on the part of the employer. Economic reasoning is required to understand that the total wage consists of cash payments paid directly to the worker plus expenses incurred on the worker’s behalf by the employer. The opportunity cost of providing employee benefits is less money available for the payment of wages. (If you are not familiar with this idea, see a text on the marginal product theory of wages, for example, Man Economy and State, Chapter 7).

Another cost of the three- and four-party system is the needs and requirements of intermediaries who come in between the consumer and the provider. The provision of care now must satisfy not only (or maybe not at all) the consumer, but the insurer, the employer, and actual or potential attorneys and regulators. Another advantage of a cash payment system would be the elimination of these intermediaries.

The present debate about health care reform must not remain a debate about insurance reform. We should be talking about what is the best system for everyone to obtain care at a reasonable price. Insurance plans with high deductibles and low premiums might be part of the solution. But the word insurance should not be used to mean the same thing as care itself.

All of the energy that is presently expended arguing about insurance has crowded out the more fruitful discussion of alternative payment models, including a cash payment system directly from consumer to provider. Contrary to Obama’s statement, people would not worry so much about health insurance if health care itself were a normal good that they could afford out of current income.

Robert Blumen [send him mail] is an independent software developer based in San Francisco.

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