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Why Health Insurance?

October 21, 2009

What people need is health care. Yet on both (or every) side of the current health care debate the discussion centers on how people will obtain insurance, not how people will obtain health care. Why is it assumed by everyone that a third-party payer should be the primary way that people pay for health care? And that the obligation of the third party to pay should be secured not by the consumer but by a fourth party (their employer or government)? Even Dr. Robert Murphy on Mises.org devotes most of his space to analyzing the problems with insurance in his discussion of the current system.

For almost every other good or service in our lives, people pay cash out of current income, obtain credit, or save up cash reserves. Insurance plays a role in only a minority of our purchases. Off hand I can think of residential property destruction, car theft, and accidental death or permanent disability as the other common forms of insurance for consumers/property owners.

Even more troubling to me is that the meaning of the word insurance has become corrupted in public discourse. What most people mean when they talk about obtaining health insurance is “How can I find a third party who will provide me with unlimited consumption of health care at no or minimal cost to me?” The current health care debate seems to be about the search for a system where everyone can obtain unlimited care at no cost to anyone.

I believe that employer-provided plans are responsible for the illusion of no cost to the insured. Most employed workers do not understand that they pay for employer costs incurred on their behalf through reduced wages. The tax system is partially responsible for this — by making the employer’s but not the employee’s premium payment tax deductible — but that is not the whole story. The lack of economic reasoning by the general public is also partly to blame. Few realize that the opportunity cost to the employer of providing the plan is less money available to pay wages.
But even if employers were not paying for insurance, why does everyone assume that a third-party payer is the best model? Let’s go back to the definition of insurance and then address this question.

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating loss.

Insurable risks share certain characteristics, among them, a small risk of loss, the magnitude of a loss would be too great for the insured to afford, and when the risk is spread over a large number of similar cases, the premium for each insured is affordable. For market conditions to make insurance a sensible model, a risk must meet all of these characteristics.

Let’s segment health care consumption into various categories:

  • predictable care: annual physicals, tests you get every year, getting your teeth cleaned, care for a chronic but manageable condition, e.g. a medication or regular chiropractor visits, or a planned event such as giving birth
  • unpredictable non-serious care: minor injury, tooth cavity, a cut
  • unpredictable but serious health emergencies: getting hit by a car, a life-threatening illness

The first two of these categories are clearly not insurable because the risk of an event is close to 100%. The third category is the best suited for the insurance model, but even then, only if the cost of obtaining care for an accident or illness is necessarily too great for an individual to afford and the likelihood of such an occurrence is small enough that the risk can be spread over a large population of insured.

I frequently hear people ask, “how can someone with an illness obtain insurance?” If you think about this for a moment, the question doesn’t make any sense. It would not make sense for an insurer to insure someone who already had incurred the insured risk. What the sick person needs is care, not (necessarily) insurance.

it is not clear a priori that the cost of care would be too great for the ill person to afford. Current prices for care are quite high, but the prices of health care as they are now have a lot to do with the four-party system. This has resulted in a system where prices are high in part because we have insurance, yet we must have insurance because prices are so high.

Prices would be a lot different under a cash-paying system, for several reasons: people would become price-sensitive in their consumption decisions; costs in the provision of care would not be generated by monitoring costs created by a third party payer; and providers would have to compete on the basis of price. See this discussion of health care in India for a case study.

In making the calculation of whether they could afford care without insurance, people ignore how much purchasing power they are already giving up in terms of lower wages due to employer-provided plans. If your employer is providing a family plan that costs several hundred dollars per month, this is costing you thousands of dollars annually in lower wages. Having your employer purchase a policy on your behalf also creates the well-known inconvenience of lack of portability of plans when you change jobs. I have not seen anyone address the cost in lost wages of people not changing jobs due to health care portability. I know that this is an issue because I have heard many people talk about the insurance as a factor employment decisions. I wonder how many people do not change to an (otherwise) better job due to the portability issue.

I won’t begin to discuss the problems created by supply restrictions.

We should not limit the discussion to insurance reforms: we should be talking about what is the best system for everyone to obtain care at the lowest price. Insurance may be one means of securing this, but the word “insurance” should not become synonymous with care itself. Focusing all of the discussion on the best model for insurance leaves out the more fruitful discussion that would result if we began to compare alternative payment models, including a cash payment system.

It is my view that the four party system is an artifact of the regulatory regime, not a successful market model for payment. In a deregulated market, most care would not be paid for by insurance companies; it would provided in return for cash payments directly from the consumer to the provider. Insurance, were it used, would only make sense with very high deductibles and low premiums in order to segregate routine care from infrequent but high cost risks.

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