Health "Insurance"

2010 February 11
by Daniel Lakeland

I've been having a lot of discussions about the Health insurance Reform stuff going around the news these days. One of my very favorite Philosophers of Science, Michael Bishop and I have been having discussions on Facebook. I figure it's time to put some basic ideas out there on the blog. I have a lot to say on the subject, so I'll put a break here:

What is Insurance

True insurance is a scheme whereby a large number of people each pay a small regularly scheduled amount (a premium) to an insurance company, in exchange for a promise that if one of a set of unlikely events happens, the insurance company will pay the bulk of this unlikely expense. The money from the premium is invested and used by the insurance company to make profit, and because the high expense events are infrequent, the total amount of the premium payments is enough to cover the total payed out. In particular, it is not possible to insure against any frequent common expense since this common expense is paid by most everyone, its amount must be reflected approximately dollar for dollar in the premium. This is the definition of real economic insurance, and is the only definition of insurance that I'm going to use here. The kind of health plan that many people have especially through their employer, where the health plan pays almost all expenses with small co-pays is not insurance, but rather a mixture of an insurance plan (since it does take care of rare events), and a form of contingent wages (wages that people only receive the benefit of if they get sick). Since most people have everyday expenses, those amounts that the insurance company pays are basically a way for the employer to funnel money behind the tax man's back into the pockets of their employees.

When insurance doesn't work

Statistically speaking, an insurance company charges more for a premium than the average cost of actually taking care of the problems that they insure against. This additional amount covers overhead and profits, so it's more expensive to buy insurance than to pay out of pocket if you have an efficient market for health insurance. However in practice we have a system where only insurance companies buy health care in bulk, ahead of time, and for a variety of reasons health care providers will charge you less if you have insurance. But the fact remains that being an insurance company involves a variety of expenses. If the insurance company can reduce its expenses, it can make more money. The easiest and obvious way to reduce its expenses is to figure out legal ways to renege on its promises. If by some loophole they can drop a newly diagnosed cancer or diabetes patient, then they can save hundreds of thousands if not millions of dollars. Since there are relatively few of these patients, it is also very hard for these patients to fight back on such actions. This is the most serious structural problem in the insurance market, and is ripe for proper regulation.

Guaranteeing access, and "moral hazard"

One problem with insurance is that the people who buy it no longer have strong financial incentives to avoid actions that might prevent the events they are insured against. It is a well understood phenomenon which has been confirmed in many studies that people who have insurance do tend to take somewhat larger risks. The Economic Term for this behavior is "moral hazard". Most people have strong non-financial incentives to stay healthy so this phenomenon is manageable in health insurance, but there is a second issue.

It's no good for the success of an insurance scheme if the customers wait until they already know that they need care before they start paying any premiums. If everyone can wait around spending their money on other things and then suddenly when they find out they need $1M of health care, they start paying a piddly $300/mo or something then there is no pool of money to pay for the $1M. Insurance works because large numbers of people pay small amounts all the time.

Recent health care reform has focused on trying to ensure that everyone can buy some form of health insurance without any reason why they can be denied. I am in favor of having such laws, but in the absence of some other system these laws make it possible for people to wait around until they need expensive insurance and only then buy in, and therefore they create a way to "game the system". These people are known as "free riders" since they take advantage of the benefits without paying.

Getting things right: The present value calculation

A person who waits around for 5 years with no insurance, and then suddenly realizes they need it to pay for an unusual event is cheating the system. Preventing such cheating is fortunately very easy theoretically. While it is important to prevent insurance companies from cheating by dropping or refusing the few who need the expensive treatments, it is also important to protect the system from bankruptcy by "free riders". The solution is to back-charge free riders so that free riding doesn't pay off unless you really never get sick (in which case it wasn't really a free ride). Moving payments from one point in time to another requires a kind of calculation called "present value", a dollar paid 10 years ago is worth more than a dollar today by the amount of money you could have earned by loaning out that dollar.

Age Inversion and End of Life care: When the unexpected becomes the expected

As people age, they naturally need more care. An event like getting a cancer is considered an unusual event for a 35 year old person, but it becomes a totally expected event for people as they get older. A 90 year old person without cancer is a fortunate person. Most people die before 90 years, and if they are fortunate to live that long eventually biology takes over and cancer becomes very likely. Currently the Medicare system takes care of people over age 65, which is a population that needs significant amounts of care. Unfortunately, so far, the only thing we can say about life span with probability equal to 1 is that it will be finite (we all face death and taxes).

People in the know about end of life care have told me that it represents perhaps 90% of all health care spending per capita currently. Most of end of life care is desperate attempts to cure nearly incurable cancers, and extends life only a few weeks or months. These last few months are usually spent in pain, unable to speak due to tubes down your throat, all those sorts of things.

With the existence of health care schemes like Medicare, a patient who faces 999/1000 odds of dying of their newly diagnosed cancer does not necessarily have to consider the financial aspects of the decision to try for that extremely expensive 1/1000 cure. The insurable condition in these cases though is the unusual event that you might actually be the one who is cured. It makes the most sense to force people to pay for their end of life care out of pocket, and then in the unusual case where they are miraculously cured and live significantly longer than expected, the insurance company would then re-pay them so that they can afford to enjoy their extended life.

My Health Insurance Reform Proposal

  1. Force insurance companies to sell only to individuals and families. It makes no sense to turn an important insurance function into a back-door for increasing wages without paying taxes. Doing so also places a lot of power into the hands of the employer to prevent the employees from leaving their company, which prevents labor liquidity (the ability to move from job to job, or to be self employed).
  2. Force insurance companies to offer a set of basic true insurance policies, at flat rates adjusted only by age, smoking status, and perhaps a small number of other activities which present a significant moral hazard (reckless driving and speeding tickets for example). Such insurance policies should provide no or very small payments until the patient has already spent some significant fraction of GDP/capita/year, for example 10% to 15% which is currently about $4k to $6k in a year. After this deductible, the insurance should pay a large fraction, perhaps 80 to 90% of expenses, up to a cap of say 20% of GDP/capita out of pocket. The transition could also be somewhat gradual rather than a strict threshold. These are large amounts but they are relatively infrequent for most people.
  3. These real insurance policies should also include health-status insurance. That is, they should guarantee a lower deductible for those few people unfortunate enough to be diagnosed with chronic long term illness. Since this is rare, it can also be insured against in a legitimate way
  4. To prevent the possibility of Free Riders, our scheme should eliminate the benefit of free riding. My suggestion is that anyone applying for these real insurance plans may not be refused, but they may be back-charged for any time during which they can not document that they were covered by some form of insurance. These back charges are valued at present value, inflating the missing historic premiums to current dollar amounts, and this back charge would then be financed into the current premiums if the patient could not pay them up front. A scheme for what would be allowable finance rates and terms should be figured out.
  5. Every real health insurance policy would include unexpected life extension insurance. People who choose to have end of life care that has a low probability of success would be forced to pay for it out of their life savings, but if they were fortunate enough to be successful, they would be re-paid in some form, perhaps a mixture of up-front payment and monthly payments thereafter.
  6. Insurance companies could still offer "deluxe" payment plans (they aren't insurance by my definition) with low copays and no deductibles and soforth, but these plans would be purchased by individuals, not by employers as a way to secretly boost wages, and they would be allowed to reject people for pre-existing conditions and soforth as currently done.
  7. Finally, to help people save for the inevitable deductibles, we would merge IRA, Roth IRA, and HSA accounts into a single Human Capital Development account. People could put up to say 10% of GDP/capita per year pre-tax into these accounts, and invest them for retirement or for health or education expenses in an independent way from employment plans like 401k.

There, was that so hard?

Haha, good luck getting this scheme through any political process. Mike Bishop and I both agreed that there is no-one in politics currently advocating for some serious market and economic theory based reform such as this one. Perhaps if I put it out on the blog someone will pick it up and run with it? I'm not holding my breath.

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