Since health care promises to be a major policy debate in an Obama administration, I plan to write a number of posts on the subject. This first one discusses insurance, one of the most fundamentally misunderstood parts of our health care system.
The first thing to understand is how insurance is priced. Because of its relative simplicity, annual term life insurance provides a good example of insurance pricing. Let's say you purchase a $100,000 term life insurance policy. This means that if you die in the next year, $100,000 is paid to your beneficiaries; if you don't pass away, you get paid nothing.
If actuarial studies suggest someone with your age and other relevant characteristics has a 1% chance of dying in the next year, the expected value of the payment to you is $1,000 - where the expected value is the total payout ($100,000) times the probability of the payout occurring (1%).
So the insurance company needs to charge you at least $1,000 for this insurance policy, to cover their expected insurance payment to you. But they also have to pay administrative costs and earn a profit, so the cost to the consumer needs to be greater than $1,000 - let's say $1,200.
Health insurance, and all insurance, share this basic fact: the cost to the consumer needs to be greater than the expected insurance payment, otherwise the insurance company will lose money and won't offer the policy.
In some ways, insurance is a bad deal for consumers. In the example above, you pay $1,200 to be paid $1,000 on average, for a "loss" of $200. But the key is "on average". You get either $0 or $100,000, and presumably your beneficiaries will need the $100,000 if you pass away (let's say to replace your lost income). Because people are generally risk averse, most are probably willing to lose money on average (the $200 "loss") in order to protect against the risk of a large loss (the income your family no longer has if you die).
Because of this, you ought to buy insurance to protect against large, unexpected losses. For example, although light bulbs burn out at uncertain intervals, their cost is sufficiently low that it doesn't make sense to buy insurance to protect against their demise. Likewise, although an apartment dweller's monthly rent is a very large cost, it is a certain cost. In both cases, you don't want to pay the insurance company's administrative costs/profit for either variable, small losses (light bulbs) or certain large costs (rent).
Another key concept in insurance is moral hazard, which means that a person with insurance may behave differently than if they didn't have insurance - and create more insurance costs than otherwise. While this is a small problem for life insurance and is addressed by preventing payouts for suicide, it is a much bigger problem in health insurance.
For example, if you had to pay the cost of emergency room or doctor's visits out of your own pocket, depending on the nature of your health problem you might choose to see your doctor than go to the more expensive emergency room. If you had an insurance policy that paid 100% of all your costs (as an extreme example), you would bear no direct cost for choosing to go immediately to the emergency room - so you might do so when you wouldn't have without insurance.
Because of this, insurance companies might actually assume that you will incur higher health care spending merely because you have insurance. For example, imagine a health insurance policy that cost $15,000 and paid 100% of all health costs - so the total cost of health care is $15,000 no matter what. Now imagine a second policy that costs $4,000 and has a $10,000 deductible, beyond which insurance pays 100% of all health costs.
This second policy is far better than the first. Why? At most the person pays $14,000 in health care costs ($4,000 for insurance and $10,000 in deductible costs) and very well may pay less (if there are only $2,000 of claims, the total cost for the year is $6,000) - in all cases paying less than $15,000 of certain costs with the first policy.
While my example is hypothetical, the pricing of actual insurance policies can exhibit these characteristics. This can result because of the lack incentives that the first, no deductible policy provides for the insured to minimize health spending.
So here is the point of all this: most health insurance for much of the past 50 years violates these basic principles of insurance. While covering large unexpected costs, health insurance has also typically covered many routine expenditures that may not be both large and unexpected. In doing so, this has given consumers an incentive to over-utilize health care, since if you bear a small portion of the direct cost of providing desired health care, you will use more health care than otherwise.
The solution to this problem is to purchase high-deductible health insurance policies. Such policies have only recently started to gain traction due to changes in the tax code.
Why does the tax code enter this discussion? Because the entire discussion above assumes there are no tax benefits between choosing one type of insurance policy over another. But that hasn't been the case. The tax code allows health insurance to be a tax deductible business expense but is not taxable income for the employee, unlike wages/salary/bonus which is a business expense but is taxable income for the employee.
So this means we have had an incentive to take more of our income in the form of tax-free benefits like health care, with the greater the cost of insurance, the higher the tax savings. As we have seen, greater insurance cost corresponds to health insurance with low deductibles and low co-pays - which is the same insurance policy that reduces significantly the incentives of the consumer to minimize health care spending.
And now you have one of the key elements behind skyrocketing health care costs in America.
