The Problem of Being Overinsured

One of the arguments for health care reform is that millions of Americans with employer provided health care are underinsured. Proponents of this view are saying that people are underinsured if they are paying too many of their health care costs out-of-pocket. A little reflection on what insurance is and is supposed to do suggests that the problem is really the opposite- many, if not most Americans are overinsured- they have too much health insurance coverage.

On what basis can I claim that Americans have too much health insurance? The purpose of insurance is to protect people from risk. Private companies offer affordable insurance against losses from automobile accidents, accidental death, fires, storms, and floods, among other things. These kinds of insurance arose in response people’s willingness to pay for a contract that will compensate them for losses due to a relatively low probability event over which the insured party has little or no control. Yet, unlike other kinds of insurance, most of what is covered by many health insurance plans does not fit this description. This is why so many people who do not have employer provided health insurance are either uninsured or purchase only catastrophic coverage.

The problem with many existing health insurance plans is that they cover the cost of routine treatment for illnesses, such as colds and flu that occur frequently or the cost of care for conditions, such as pregnancy, that are heavily dependent upon the choices of the person who is insured. Basic economics teaches that paying for routine treatment via a third party insurance company will raise the total cost of that treatment. This happens for two reasons. First the insurance company, as middleman between the consumer and the health care provider, has costs that must come out of what the consumer pays. Second, insurance that pays for routine care lowers the cost of each doctor visit to the consumer, thus increasing demand. Higher demand with a given supply means higher prices.

It does not matter whether consumers or employers pay health insurance premiums. The premiums are part of the cost of health care. Eliminating routine care from being covered by health insurance would mean premiums would decrease and employers could pass the savings along to their employees as higher wages. The average consumer would be better off as a result. If it were not for the tax deductibility of health insurance premiums, employers would not cover routine care and avoidable conditions as much as they do.

This is not to deny that many Americans do not have sufficient access to affordable health care nor that the inability of some to afford health insurance is something we should be concerned about. Although it does not make sense for insurance to cover the ordinary medical costs of child birth, treating chronic asthma, or flu symptoms, it may be a good idea to have insurance in case of complications resulting from childbirth or to cover hospitalization for pneumonia and other serious illnesses.

The best way to help those who cannot afford basic health insurance is not to require or subsidize the kind of comprehensive health insurance plans that most employers now offer. On the contrary, health care costs and the cost of health insurance that would cover life threatening illnesses and serious accidents would be considerably lower if the existing system of taxes, subsidies, and government regulations did not result in so many people being overinsured.

Controlling Health Care Costs when Government Pays

Government, as a purchaser of health care, has sought ways to control health care costs. One of the more effective approaches that helped bring Medicare costs down was the prospective payment system (PPS). Instead of paying hospitals for the services that they provide, under PPS, the government pays them per case. Medicare began offering a fixed payment for each patient admitted to a hospital based on a diagnosis related group (DRG) that the patient was assigned to.

Offering a fixed payment per patient has both advantages and disadvantages. A big advantage is that it offsets the incentive of doctors to provide additional services to patients when the marginal benefit is below the marginal cost. When the government or insurance companies pay doctors and hospitals for the services they provide, patients will usually agree to additional treatment recommended by their doctors, even if it is not cost effective. Many patients would not agree to additional treatment if they had to pay out of pocket. The prospective payment system has been quite effective at reducing the average length of hospital stays without any evident decline in the health of those treated.

One problem with paying a fixed payment for each case is that it fails to account for differences between patients within each treatment category. Each patient will receive the treatment that the government deems necessary for the average patient with a given health problem. Some patients may need more than the average while others need less. Offering a fixed payment also reduces the incentive of hospitals to compete on quality. Hospitals will have an incentive to pursue quality improvements that are accounted for by the government’s payment formula (such as changes that hasten patients’ rate of recovery). If they cannot charge the extra cost of a quality improvement to the government or an insurance company, hospitals will only pursue it if patients are willing to pay extra for it out-of-pocket.

When government or insurance companies pay for health care and limit their payments via a PPS system, covered patients need not get too few health services or inferior quality services provided they have the freedom to choose their doctor or hospital and to pay whatever PPS does not pay. In this case, patients could pay extra out-of pocket to get extra services or superior quality care if they value either more than the additional cost. By contrast, government payment will lead to some patients getting more health care or higher quality than they are willing to pay for. As long as a third party pays most of the cost of a procedure, some people will consume more health care than is consistent with their preferences. Although paternalistic arguments can be made for this approach, government lacks the information to account for all the factors that might justify giving priority to some patients over others in using scarce health care resources.

It is a good thing when government takes steps to limit health care costs as they have done with the PPS system, as long as patients are permitted to pay extra to consume more than the limited quantity or quality of service covered by the insurance or government program. There is, however, a fundamental problem with this approach, which is part of the reason why Medicare costs continue to rise so fast that Medicare appears to be financially unsustainable.

No matter how carefully a hospital is at diagnosing a patient when he is first admitted, hospitals often do not know ahead of time what sequence of treatments will be most effective for each particular patient. As a result, Medicare allows retrospective cost sharing based on treatment decisions hospitals make long after the initial diagnosis. It is often unclear whether a certain treatment is appropriate for a given patient. The more that Medicare allows retrospective cost sharing the greater the incentive of hospitals to err on the side of more intensive and costly treatment. As technology improves, hospitals also have an incentive to use more expensive treatments, if they can get reimbursed for the additional cost, regardless of how large or small the marginal benefit actually is.

Lacking a profitability constraint or even much of a budget constraint, government Medicare adminstrators have inadequate incentives to compare the marginal benefits of a more intensive treatment regimen with the marginal costs.

By contrast, if patients or their families were the ones paying for the treatment, they would have an incentive to make treatment decisions based on a comparison of anticipated marginal benefits with marginal costs. This would provide a much more powerful incentive to control costs than PPS provides, as it is currently administered by the government. The best way to control the costs of medical care for the elderly is to have patients and their families bear a greater share of the costs of medical care, since they are the ones most likely to make choices that will promote a cost efficient level of treatment.

The Case for and Against an Individual Mandate to Buy Health Insurance

A major concern with health care in the United States is that many of those who most need health care are unable to get health insurance- either because they would be charged higher premiums or not fully covered by employer plans, due to preexisting conditions. An important goal of health care reform was to make sure that all, regardless of the state of their health, could get affordable insurance coverage. Accomplishing this while maintaining some semblance of a private health insurance market is difficult.

In a free market, health insurance companies set premiums based on expected health care costs, and those costs will be much higher for people with poor health. While some employer plans continue to insure people whose health deteriorates, it is difficult for those with preexisting health problems to find a job or qualify for full health insurance coverage if they do.

If the government requires health insurance companies to cover everyone who applies without charging more for those with poor health, a problem known as adverse selection arises. Insurance companies will set a premium high enough to cover the average person who is likely to buy insurance from them. Given the choice, however, many people who are healthier than average will choose not to buy this insurance because they are unlikely to visit the doctor enough to justify the premiums they will have to pay. Almost everyone whose health is worse than average will perceive the premiums to be a bargain and will buy this insurance. The resulting below average health of those who choose to buy insurance will cause premiums to rise, making buying insurance worthwhile only for those in very poor health.

The problem described above can be overcome either by government providing health insurance for all at taxpayers’ expense or by mandating that everyone buy health insurance. The only way to sustain a private insurance market when companies are required to insure everyone without discriminating against those with preexisting health problems, is to mandate that everyone, especially those who are relatively healthy, must buy insurance.

Is it possible to have a system that does not discriminate by price based on preexisting conditions without some kind of individual mandate? The short answer is no. Hence the only way to guarantee affordable health insurance for everyone is to take away individual freedom. Although access to affordable health care may sound like a good reason for Americans to sacrifice some freedom, it is not. As I will discuss in future blogs, the argument that everyone should be able to purchase health insurance on the same terms is inherently flawed and does not hold up under careful scrutiny.

There ain’t no such thing as a free lunch (or free healthcare)!

A few days ago, I received an email from the daughter of our Congresswoman. In the email she explained that because of Health Care Reform, which her mother supported, she no longer had to pay a $25 co pay for each prenatal appointment. This will save a family “that lives paycheck to paycheck” over $500 per year. Such savings makes healthcare reform sound like a wonderful gift until you stop to reflect- who pays the $25 that the consumer no longer has to pay each time she visits the doctor? The answer: for those who have health insurance, the elimination of copayments will mean higher premiums. In other words, paychecks will become smaller as insurance rates rise to cover this new government mandate.

Proponents of this new rule emphasize that if people do not have to pay for preventative care, they are less likely to require more expensive hospitalization or treatment in the future. Thus, mandating no copayments on preventative care may reduce health care expenditures in the long run. This line of argument is fundamentally flawed. It assumes that the government knows or can find out how much preventative health care each person needs and mandate insurance companies to pay for the required number of visits. How many doctor visits are covered as preventative will be a political decision, and self-interested medical professionals will undoubtedly play an important role in that decision. Thus we should not be surprised if the government mandates more free preventative care than would be cost effective for most patients.

We live in a world of scarcity. Money spent on health care cannot be spent on something else. If the insurance company provides a certain number of free doctor visits, each person covered by insurance will pay for the number of times the average person visits the doctor, regardless of how often he visits the doctor. One person’s visit to the doctor has an imperceptible impact on the per capita cost of health care borne by a large insurance company. Thus the monetary cost to each patient of a visit to the doctor for “preventative care” is effectively zero. The quantity of health care demanded will be greater at a zero price than at a $25 price. Since almost everyone will demand more health care at the zero price, insurance premiums will rise for everyone, and because more health care is being consumed, the total cost of health care will be greater than if everyone had to pay a $25 (or higher) copayment.

If you are covered by a typical health insurance plan which requires you to pay part of the cost of each doctor visit, Congress has not saved you money by passing health care reform. Instead they have mandated that you spend more than you might choose to spend on so-called preventative health care. If you don’t pay for it up front with a copayment, you will pay for it through higher premiums. The only way to keep people’s premiums from rising is if the “free” care is taxpayer funded, and then someone still pays for it.

Instead of Obama Care, which takes away our freedom, what we need is health care reform that gives the consumer more freedom to decide how much health care to purchase with his own money.