The Agenda

Is Reforming the Individual Insurance Market Enough?

In Health Reform Without Side Effects, Mark V. Pauly makes the case against guaranteed issue and community rating. As Pauly explains, the central danger involved in community rating is the following:

The most serious unintended adverse consequenceis that, if it is implemented in otherwise competitive insurance markets without targeted subsidies, insurers required to underprice (relative to expected benefits cost plus loading) for higher risks must overprice policies sold to lower risks in order to cover their total cost. The consequence of this price distortion isthat lower risks will drop or fail to buy coverage. There is substantial evidence that this is what happens, and to such an extent that community rating actually causes more people in total to be uninsured, even as it modestly reduces the number of uninsured high risks.

Pauly also explains the persistent political appeal of community rating:

From the viewpoint of economic efficiency, subsidizing high risks is often desirable, but paying for that subsidy by taxing low risks never is. Noris there an obvious equity reason why low risks should pay. The reason for the political appeal of this policy isthat the tax on low risks is not counted as a tax, doesnot show up on any budget, and is opaque for all, even to low risks who are likely to blame the insurers, not theregulators, for their high premiums.

Pauly also calls for reforming the individual insurance market. To follow Pauly’s argument, it’s important to understand the concept of “loading.”

The real cost of protecting yourself against the risk of uncertain medical spending is the difference between what you pay or would pay for health insurance and what you expect on average to get back as benefits. For a set of similar risks buying the same policy, this cost is the difference between total premiums paid and total benefits received; in insurance parlance this is called the “administrative loading” (or just “loading”) on insurance. This measure of insurance price or cost is not perfect since it does notcapture the offsetting benefit of getting more care than if one were uninsured, the offsetting cost of that care, and the nonmonetary cost of being limited in what care you can get and from whom by a managed care insurance plan. But it will do for a start. Economic theory and definitive empirical research tell us that the higher the loading, the less attractive is insurance, other things equal, and the more likely people are to choose to be uninsured or not make strong efforts to become and stay insured. The punchline: the worst off a person orgroup can be is when they are often uninsured andwould pay a high loading for insurance if they got it.

Subsidies can create a virtuous circle by lowering loading costs. 

 Subsidized insurance is more efficient with regard to administrative cost because of a kind of self-fulfilling prophecy: by making premiums more attractive, selling costs can be lowered, but at lower selling costs, attractive premiums can eventually become financially feasible.

Pauly also points towards how a well-designed system of subsidies can obviate the supposed need for community rating:

The purpose of costly underwriting is to identify the high-risk applicants,but underwriting requires that every applicant bereviewed. It only makes sense to spend resources on a careful review if you think there is a large enough fraction of applicants you would want to decline. If subsidies enrich the pool of applicants with many more good risks, it becomes much less cost effective to screen, andso screening efforts will decline. It would also no longer pay as much for low risks to search aggressively for policies with premiums tied to their risk levels, if high risks are not segmented out.

Pauly makes a number of sensible recommendations in his excellent book. At the risk of mischaracterizing Pauly, I’d summarize his basic approach as follows:

(1) Offer subsidies targeted at buyers with low insurance demand (e.g., “young invincibles”) to help shift insurance markets to a new, low-loading equilibrium.

(2) Create well-funded high-risk pools financed by general taxation as an interim step to aid the people who are high risk and uninsured. 

(3) Mandate guaranteed renewability.

The goal is to slowly clear the backlog of individuals who are uninsured and high risk:

One ideal version of health reform would rely almost entirely on subsidies for low-income average risks, penalties for high-income average risks, and guaranteed renewabilityto ensure that the population is insured withthe right level of insurance. The vision here is one inwhich the 96% of the population which is good to averagerisk when they reach the age at which they ceasebeing dependents would all be induced to take coverage with guaranteed renewability at that point.

But would this approach work in practice?

The most obvious problem is that some people may not, despite our bestefforts and best subsidies and penalties, initially take theneeded coverage.

In “How to Cover Pre-Existing Conditions,” an excellent, detailed National Affairs essay by James Capretta and Tom Miller, the authors offer set of proposals for reforming the individual insurance market that closely parallel Pauly’s recommendations. The emphasis remains on encouraging individuals to maintain continuous insurance coverage, and proving subsidies to low-income and high-risk individuals to make it as accessible as possible.

My main concern with the Capretta-Miller approach is the following:

When these reforms are first implemented, there will need to be a one-time open-season enrollment period to allow people who have fallen through the cracks over the years to re-establish their rights by maintaining continuous coverage. Those who have forfeited their coverage would get just one chance to become insured under the new rules (though perhaps at higher rates than those who had not forfeited their rights); once the enrollment window closed, everyone would know that people who remain continuously insured are protected, and that those who choose not to become insured have taken a risk.

Given the nature of our political culture, there is reason to believe that this approach won’t have real teeth. Many on the left will use harrowing and true stories about the misfortune that befalls those who didn’t sign up during the one-time open-season enrollment period to continue pressing for a less sustainable health system. As Mark Pauly writes:

The most obvious problem is that some people may not, despite our best efforts and best subsidies and penalties, initially take the needed coverage. Then they may become higher risk and need help. Practicality suggests that there must be something in place for this group, some way of limiting thehigh-risk premium for those people who, through bad luck or bad decisions, somehow end up as sick and uninsured.There is a trade-off here: the more we cushionthe consequences of skipping the chance to buy ideal (guaranteed renewable) coverage, the more we distort incentives—both incentives to protect against becoming a high risk and even incentives to becoming insured atall regardless of risk level. 

I’d rather embrace what we might call the Capretta-Miller-Pauly approach to reform and strive to change our political culture than, say, embrace an even more centralized, government-dominated health system than we have at present. But this is a profound challenge. And that’s why I’m so drawn to the idea of a public reinsurance program as proposed by Harold Luft. 

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