All Commentary
Tuesday, August 7, 2018

Understand How Insurance Works Before Debating Health Care Policy

Neither Obamacare fans nor single-payer pushers seem to have any clue about how insurance is supposed to work.

For at least half a century (Medicare turned 50 last year), health insurance policies have been hotly debated. The most recent skirmish is over the Trump administration’s final rule expanding the availability of short-term, limited-coverage insurance. Single-payer and Obamacare stalwarts have attacked it tooth and nail. For instance, Los Angeles Times columnist David Lazarus asserted backers “have no clue how insurance works” because they “decided to skip class when the topic of insurance came up in Econ 101.”

Unfortunately, if accurately applying principles of insurance is the standard, both single-payer and Obamacare fans compare poorly to pots calling kettles black. Their preferred policies sharply conflict with insurance principles on multiple fronts.

Insurance Is All About Risk and the Unknown

Insurance is about reducing risk from uncertain events. It makes outcomes for a group with similar risks more predictable. But that must be weighed against the additional administrative and other costs of insurance. That would mean that people would not insure against what would happen for certain nor where there is only a small amount of risk reduction provided if they were spending their own money.

Any benefits from reducing risk would also have to exceed added costs induced by insurance coverage.

Insuring things which would occur with certainty, say certain inoculations and annual checkups, offers no risk reduction. It provides no added benefits to weigh against the added costs of insurance administration, yet government plans mandate such coverage. Similarly, small health care risks are cheaper to cover directly out of modest savings than incurring the added costs of insurance administration, but government plans also mandate such coverage. Few would want such coverage unless much of the cost was forced onto others (which is how Obamacare subsidies muted criticism of such inefficiencies).

Further, any benefits from reducing risk would also have to exceed added costs induced by insurance coverage. When insurance covers most of the costs, it makes care artificially cheap to recipients, just like a subsidy (e.g., if a medical treatment cost $1,000, someone who had 80 percent coverage would face a cost of only $200). Those artificially low costs to recipients increase the quantity and quality of care they desire. That will increase medical utilization and costs (called moral hazard in the insurance literature), much of which would not be worth the real cost (e.g., above, someone who valued a $1,000 service at $250, but had 80 percent coverage, would still want it, even though it wastes $750 in value). And the ensuring waste can be very large because there are many margins at which those insured will want better care (e.g., better and more specialized doctors and hospitals, more costly newer drugs, tests, and treatment, etc.) as well as more care, raising costs (or requiring care to be rationed, making treatment unavailable, even with insurance, to those on the losing end of such allocation).

Further, differences in circumstances and preferences mean that not everyone would want the same coverage. Teetotalers confident of remaining so would not willingly insure for alcoholism treatment. Those sure they would never use drugs would not want to bear the cost of providing addiction treatment. Yet government mandates that many such medical services be covered, reflecting the political power of provider lobbying far more than the values recipients place on them.

Insurance Is Not About Price Controls or Mandated Coverage

The price controls government health care proposals incorporate also violate insurance principles. For instance, my age makes my actuarial risk roughly six times that of my students. Pooling risks among those similarly situated with me can benefit us; pooling risks among those similarly situated with my students can benefit them. Insurance is based on pooling risks among people whose risks are comparable. But incorporating more people with risk differentials (say, 6 to 1) that are different from their premium differentials (say, 3 to 1) forces the overpriced people to subsidize the underpriced people. That is not motivated by insurance principles. It is wealth redistribution.

Such a mandate doesn’t reduce everyone’s risk exposure, it just forces someone else to cover certain people’s already-known-to-be-higher costs.

It is redistribution, not insurance, which motivates that, and explains why Obamacare imposed penalties to force the losers to accept a bad deal.

Mandating coverage of pre-existing conditions, always emphasized by fans of government health plans, is also revealing. Such a mandate doesn’t reduce everyone’s risk exposure, it just forces someone else to cover certain people’s already-known-to-be-higher costs while allowing blame to be deflected onto insurance companies who must charge other policyholders more. And it is worth remembering that casinos don’t let you bet after the roulette ball or dice have stopped moving, nor are they offered in fire, automobile, or life insurance.

Equally instructive is the treatment of catastrophic coverage—the type of coverage most consistent with insurance principles—under Obamacare. It allows the most valuable risk reduction—from very costly, uncertain events—while limiting the overconsumption of medical care. But Obamacare was so slanted against them that less than 1 percent of policyholders chose the option most consistent with insurance principles. In particular, catastrophic coverage was restricted to people under 30, unless one could get a special exemption (and especially with guaranteed subsidized family coverage extended to 26-year-olds, that is a small group), and the subsidies available to those in the “metallic” plans were not available to catastrophic plans.

Politics Ruins the Purpose of Insurance

There is also the fact that insurance principles are based on actual probabilities. They do not justify lies and misrepresentations. But Obamacare was supported with a host of them, from, “you can keep your own doctor” to known-to-be-false claims of bending down the medical cost curve and providing $2600 annual savings per family. Insurance companies would not even survive such fraudulent claims. Similarly, single-payer or Medicare for all plans use estimates of costs off by trillions of dollars and preposterous assertions of how they could be funded. Such misrepresentation cannot be part of insurance policies that will advance Americans’ well-being.

One would think that government health plan backers might be more circumspect in their assertions of opponents’ cluelessness about insurance principles because the plans they support trample insurance principles beyond recognition. But then, how often do government claims of adhering to principles increase the likelihood that those claims are true?

  • Gary M. Galles is a Professor of Economics at Pepperdine University and a member of the Foundation for Economic Education faculty network.

    In addition to his new book, Pathways to Policy Failures (2020), his books include Lines of Liberty (2016), Faulty Premises, Faulty Policies (2014), and Apostle of Peace (2013).