Is Health Insurance Really Insurance – Or Something Else?

May 23rd, 2010

Recent passage of the Obama administration’s health-care “reform” package prompts reflection on the underlying meaning of health insurance. This leads to a better understanding of the causes of health-care inflation and proposed remedies.

What is Insurance?

Insurance is a process for the transfer and amelioration of risk. Risk is transferred from risk-averse people to risk managers. The managers are qualified professionals who either bear the risk or reduce it to manageable dimensions by pooling large numbers of risks.

Risk is defined by the variability of possible outcomes. An insurable risk is unpredictable at the individual level but predictable in the aggregate. That distinction is what makes insurance companies both necessary and useful. You can’t accurately predict your particular outcome, but by pooling large numbers of outcomes, insurance companies can accurately predict aggregate outcomes. This enables the companies to manage risk by holding economic reserves sufficient to pay for the resulting claims.

Insurance companies charge premiums for the insurance they provide. The basic function of the premium is to compensate the insurance company for the risk it assumes. Logically, this requires the insurance company to charge higher premiums to people who impose larger risks on the company. In some cases, they may deny coverage altogether. By making the cost of risky behavior higher, insurance premiums reduce the total amount of risk. This is a broadly beneficial function.

How Did Today’s Health Insurance Develop?

So far, we have said nothing about health insurance per se. Instead, we have identified the broad general principles that define insurance as an economic category. What relationship does health insurance bear to archetypal insurance?

In the U. S., most health insurance is provided by employers as an employment benefit, rather than purchased by individuals. This practice became widespread during World War II. The federal government slapped controls on prices, wages, and salaries during the war. (Wartime is the classic occasion for inflation, since governments often resort to money creation to finance the war.) Since employers were unable to offer wage increases to reward and lure labor, they chose instead to offer employee benefits such as health insurance. Employees had an incentive to accept the benefits because health insurance is very broadly useful. Both employers and employees had an incentive to adopt this system because health insurance benefits were a deductible business expense to the employer and were not counted as taxable income to the employee.

Great oaks from little acorns grow. (Perhaps that should be “oafs.”) What started out as a way of circumventing wartime price controls persisted because of the special tax status accorded to employee benefits. At first, the insurance policies were fairly conventional – high-deductible, catastrophic-type policies designed to protect the insured against the financial calamity of a huge medical bill. But that gradually changed.

The employee wasn’t paying the premiums (or their artificially-low premium contribution was heavily subsidized by the company). A low-deductible policy (perhaps including a small co-pay) allowed the employee to maximize the benefit of the policy while paying little or no additional money for the extra benefits. To employers, paying the bill for these first-dollar type policies was better than forking over annual raises, since part of the tab was covered by the tax deduction.

Thus, health-insurance policies gradually mutated into a form of pre-paying for annual checkups and minor medical procedures. When all or most of the bill for medical services is paid by a third party, the insured has the maximum incentive for using medical services. After all, the marginal price of those services is effectively zero, since the co-pay is the same no matter which services are bought and how much they cost.

And that, in a nutshell, is why the price of health-care goods and services has gone through the roof. Health-care is produced using resources, both human and non-human. These resources have a value that ordinarily be expressed in the market price of the goods and/or services. But health insurance lies to the insured by pretending that the price is zero. The insured buys services that wouldn’t otherwise be bought, and the prices of medical services are higher than the insured would voluntarily pay for the amount bought.

Is This Insurance?

Health insurance as it is presently constituted is a misnomer. Annual checkups, for example, are not an individually unpredictable event. They are not a risk that needs to be protected against. Neither are minor medical treatments, which would not justify the costs of setting up an insurance company to pay for them. Insurance is supposed to deter and penalize risk-taking. Since there is little or no premium felt by the employee, there is no risk-deterrent. Thus, there is no broadly beneficial reduction of risk from health insurance.

Health insurance is not insurance. It is something else.

If Not Insurance, What is it?

Health insurance is currently playing a completely unsuitable role. It allows us to pretend we have reduced the price of medical goods and services to zero. We can thus indulge the fantasy that we are getting those goods for free as a matter of “right.” In fact, medical goods and services are not free because they utilize scarce resources that have alternative uses.

The currently-popular justification for this pretense is that health care is a “fundamental human right.” This is wrong by definition. A valid right or entitlement can exist only if the consumption of the good by some people does not reduce the amount available for others to consume.

Setting an effective price of zero on consumption of medical goods and services encourages tremendous overconsumption of those goods and services. If a market price were placed on them, people would consume them only if the value they received exceeded the alternative consumption they had to give up by paying that price. We would still receive the catastrophic care that was paid for by insurance. We would buy the diagnostic procedures that we value the most, but we would be forced to limit our consumption of the medical items that we value the least. That would lower the prices of lower-valued medical goods and services. Reducing insurance companies’ expenses would eventually lower the market price of health insurance. This would allow more people to buy it, reducing the uncollected debts for emergency and catastrophic care currently being run up by hospitals.

The only way to preserve the fantasy of a zero price is to ration medical goods and services by queue and fiat, instead of by price. HMOs have already played this role by denying permission for treatments that consumers want.

When a tree is denied sunlight, its growth is misshapen and distorted by its attempts to reach the light. When health insurance is unable to function normally, insurance operations are similarly distorted by the need to maintain profitability. Instead of paying for occasional catastrophic claims, insurance companies are forced to pay for most medical expenses. Their only way to reduce these expenses is to take measures that are economically perverse; i.e., that achieve results opposite to the desirable effects of true insurance.

The companies institute lifetime limits. They dispute large claims, not small ones. (It takes just as much paperwork and legal work to dispute a small claim, but the gains are much less and the average cost much greater.) This means that consumers eventually use up their coverage and end up paying large claims. This is exactly opposite to what real insurance does.

Let Health Insurance Be Insurance

The roles played by health insurance should be its traditional ones – manage and reduce risk by correct pricing. We are living in a fool’s paradise if we believe that everybody can consume all the medical goods and services they could possibly want without foregoing a large quantity of other goods and services. The only way to determine if the medical consumption is worth that alternative consumption foregone is to attach a price tag to each unit of consumption. That allows us to weigh the relative value of goods and services each time we consume them.

Reducing “Costs”

Both sides in the current health-care debate claim to be reducing health-care costs. They are wrong. The costs of health-care derive from the inputs used to provide it – human labor, machines, drugs, etc. The true costs of health care are the value of those resources in their highest-valued alternative uses. Current policy proposals aim at reducing expenditures, not costs. Preventing people from spending money does not reduce the costs of what they want to buy. Costs influence the supply decisions of producers, not the demand decisions of buyers.

A Big Step in the Wrong Direction

Instead of restoring the proper functions of health insurance, current policy takes big steps in exactly the wrong direction. Vastly enlarging the market with universal health “insurance” that recognizes no pre-existing conditions will require much more comprehensive rationing. That is the role played by governments or quasi-governmental agencies in other countries. By propping up a system that suppresses consumer valuation, rationing will prevent many consumers from getting medical goods and services they want at a price they are willing to pay.

The only legitimate role health insurance can play is the role of genuine insurance – to substitute cost for risk, transferring and reducing risk in the process. The direction of current policy is diametrically opposed to that genuine role.

Category: Economic Analysis, Insurance, Risk | Tags: , , ,

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