Optimally financing society’s medical expenses

Posted: April 17, 2012 by alephnaughty in Economics, Health, Law, Philosophy, Politics
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Thought experiment: Suppose we were to institute a free market in medical finance—that is to say, permit consumers of medical care and producers of financial instruments to enter into whichever kinds of consensual transactions (pertaining to medical finance) they choose, without favoring any particular model(s) by means of public policy. What is there to fear in such a setup?

Concern #1: The poor would not be able to purchase a decent minimum of health care without giving up other essential spending (e.g., shelter). They do not deserve to be in this position—they consciously chose neither their genetic endowments, nor the childhood environments in which they were raised (nor the social circumstances they inherit, for that matter). It is unfair, therefore, to deny them standards of medical care that their more fortunate peers would be able to secure for themselves in the marketplace.

Reply: Indeed. The solution is to transfer wealth from those who have more of it to those who have less of it, up to a point. Such transfers discourage the creation of wealth. We must, therefore, delicately balance our desire for fairness with our desire for prosperity. I do believe, however, that doing so would leave us with ample room to improve the relative plight of the poor.

Concern #2: Cutting poor people checks is only part of the solution. What if, instead of purchasing necessary medical care, for example, a poor person blows her transfer payments on drugs?

Reply: Is she obviously engaging in self-destructive behavior? If she is, then there is a case for encouraging her to spend her money more constructively. A simple subsidy (e.g., a tax break) for buying essential medical care would probably do the trick. If she is obviously harming herself by not having particular financial products (for instance, catastrophic insurance, or a medical savings account), then specifically subsidizing her purchase of these is reasonable enough.

It is worth noting, however, that it is usually not obvious whether someone is engaging in self-destructive behavior. Our everyday decisions force us to make immeasurably complex calculations, which in turn draw upon extensive information about our preferences and the circumstances we inhabit, data concerning which is frequently inaccessible to outside observers.  This is neither to say that humans never engage in self-destructive behavior, nor that outsiders never improve upon the decisions of others. Instead, my claim is simply that it is not often the case that someone is obviously doing harm to themselves. As a consequence, the burden of proof is borne by those who want to encourage people to make different decisions—and it is a heavy burden indeed.

Concern #3: These proposals address the unfairness of some people being less wealthy than others, but they do not address the unfairness of some people being less healthy than others. Why should some have to pay more for medical care than others, simply because their health is in poorer condition (through no fault of their own, needless to say)?

Reply: It is not just sick people who have to pay more than their peers to remedy their God-given deficiencies. Ugly people, too, have to pay more than their peers to look better to others, to feel better about how they look, etc. Stupid people have to pay more than their peers to do better in school, or to do better on the job, etc. These observations do not serve to trivialize poor health. Instead, they underscore the uniqueness of economic inequality as a policy objective.

Usually, a very wealthy sick person is much better off than a very poor healthy person, because a poor person is likely to have many more problems to worry about besides her health, while having few resources to throw at such problems. A wealthy person, by contrast, is likely to have many fewer problems to worry about besides her health, while having a lot of resources to throw at the problem. The problem of poverty is not a problem of having inferior housing, or low-quality education, or inadequate nutrition—it is a problem of not having enough money. To a large (though far from complete) extent, the problem of ill health is a problem of not having enough money, too.

On a more practical note, just as transfers from rich to poor discourage wealth creation, transfers from healthy to sick encourage unhealthy lifestyle choices, which play a large role in shaping longer-term health outcomes (according to some experts, a much larger role than adequacy of medical care). Policies like ‘community rating’ effectively enact such transfers, driving up the cost of medical care in the long run. Consider this one more reason to focus discussions of fairness on economic inequality, rather than on health inequality.

Concern #4: What about spillover effects? Suppose people decide to forgo vaccination for a contagious disease, knowing that they may free ride on others’ vaccinations. Should we not encourage people to get vaccinated? Or consider the fact that our society simply is not going to let poor people with medical emergencies die in the streets. In light of guaranteed emergency care, should we not demand that everyone be able to pay up in the event of a medical emergency?

Reply: In principle, this is unobjectionable. In practice, it is a question of magnitudes. If the social cost of uncompensated emergency care, for example, is very high indeed, then mandating and subsidizing purchase of catastrophic health insurance is sensible enough. Similarly, if a disease is sufficiently dangerous and sufficiently contagious, subsidizing vaccinations is entirely appropriate. Where the social cost is low or negligible, the cure may prove to be worse than the disease, pardon the pun.

Another example relates to our earlier discussion of lifestyle choices. If the reason why uncompensated emergency care is so costly is that people are making unhealthy lifestyle choices (e.g., becoming obese), putting them at risk of various medical emergencies, then it may make more sense, depending on the science, to discourage obesogenic diets than to make insurance mandatory.

Concern #5: Even in the context of a fair distribution of wealth, a free market in health insurance would not work to the benefit of consumers. Since insurance companies would not know as much about a customer’s health as the customer herself, they would have to charge potentially very different customers roughly similar prices. This would cause healthier people to conclude insurance is a bad deal for them, dropping out of the pool, leaving it riskier on average. Responding to this, insurance companies would raise prices, causing still more (relatively) healthy people to drop out of the pool, causing prices to rise further, and so on and so forth. In equilibrium, the market would disappear, failing to serve the medical care financing needs of consumers.

Reply: This problem, known as ‘adverse selection’ in economics, is only a problem to the extent that insurance companies cannot bridge the informational divide. In reality, they work very hard to do this, under the heading of ‘medical underwriting’. Such screening procedures are hardly perfect, but then, consumers’ knowledge of their own health risks is hardly perfect, either. There is little evidence of adverse selection in existing health insurance markets, except in places where public policy actively discourages medical underwriting (e.g., through community rating and ‘guaranteed issue’ policies, which blunt insurer’s incentives to bridge the informational divide). Remember that the goal of such policies (greater equity in the distribution of medical care) is better pursued through explicit transfers, which neither cause adverse selection, nor discourage healthy lifestyle choices.

Concern #6: The case for free markets is premised upon competition. Competition between providers of medical finance ought to, in theory, drive down prices, while increasing quality. Why, then, do premiums keep rising in our medical insurance market? Why do these higher premiums largely support profits rather than better medical care? Is it not because the market for medical insurance is intrinsically non-competitive?

Reply: It is true that the market for medical insurance in the US is hardly competitive, but this is not intrinsic to the provision of medical insurance. Economies of scale in the insurance business do give larger firms a competitive edge over their smaller peers, but there are diminishing returns to scale, and there is little evidence that monopoly, or oligopoly, is the inevitable outcome of a free market in medical insurance. The US medical insurance market is mostly non-competitive due to regrettable public policies.

On the supply side, the US restricts competition between insurers across state lines. Given economies of scale, this encourages the formation of local monopolies. Additionally, a large number of regulations at the state and local levels raise the fixed costs of being in the insurance business, costs which it is easier for larger firms to bear—this, too, encourages insurance companies to scale up beyond what is socially optimal.

On the demand side, employer-provided health insurance is tax-deductible. Consequently, most workers get their insurance plans through their employer. For the majority of workers, the choice of the right job is much more important than the choice of the right health insurance plan. This bit of tax policy thus discourages workers from smart shopping in the insurance market. Employers, in turn, do not really care which insurance plans their employees have, for the cost of these plans is simply deducted from the wages they pay. There is, therefore, little pressure from the demand side for insurers to compete on price and quality.

Concern #7: What, then, should we do about people who, through no fault of their own, would be uninsured because of pre-existing conditions?

Reply: This question reflects a misunderstanding of the concept of insurance. Why do people buy medical insurance? They do so because their health is at risk (e.g., they may get hit by a bus), and they are willing to pay some amount for someone to take the associated medical risk (e.g., expenses for having their injuries treated) off of their hands. Why, then, do people sell medical insurance? They do so because even if the future health status of each of their customers is very unpredictable, the future health status of their entire pool of customers is reasonably predictable. This is a straightforward consequence of the Law of Large Numbers. As a result, insurers take on less medical risk than their customers compensate them for, yielding insurers profit. In short, the value of insurance is that, by pooling the risks of diverse customers, it reduces the aggregate risk borne by the pool as a whole.

What does this have to do with pre-existing conditions? Simple: if you have a pre-existing condition, there is no risk to be insured. For example, if you have cancer, there is no risk that you will demand expensive treatment—this is a certainty. “Insuring” certainties does not add value to anything. What people with pre-existing conditions need is not insurance, it is money. If someone already has plenty of money, public policy need not be concerned with her. If she does not, then the solution, once more, is to give her more money.

Requiring insurance companies to cover pre-existing conditions is to require them to get into a business besides insurance—namely, the business of pre-payment and/or redistribution. We should hardly expect insurance companies to be suited for this. What ever happened to specialization?

Conclusion: I could go on and on, but I think you get the point. There is little to fear in a free market in medical finance that a few, simple, well-designed subsidies cannot fix. Such subsidies warrant caution: I have been writing of the market for medical finance instead of the market for medical insurance, because this is not something we should pre-judge. Insurance was once a novel financial instrument. Innovation in medical finance may one day render it obsolete, which is something public policy should not get in the way of with outdated subsidies. Even today, we likely rely too much upon health insurance, when we should also be relying on medical savings (the tax-deductibility of employer-provided health insurance favors premium-heavy insurance plans over deductible-heavy plans, for example). Insofar as the many purported problems with free market health insurance are really problems, however, the right fix is delicate subsidies, not command-and-control regulation.

With the Supreme Court likely to strike down the PPACA’s individual mandate, comprehensive reform may soon be back on the agenda. Here’s to hoping that future proposals focus on deregulating the health insurance industry, ending the tax-deductibility of health insurance, and converting programs like Medicare and Medicaid into lump-sum subsidies for the poor. If, in such a liberalized, egalitarian environment, many people continue to do obvious damage to themselves by failing to purchase enough medical care, or by failing to purchase the right sorts of financial instruments pertaining to medical care, then we ought to discuss in more detail the merits of subsidizing this or that.

Of course, I have deliberately ignored the elephant in the room—the ballooning cost of medical care itself. For another day, I guess.


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