The recent debate over the potential repeal and replacement of the ACA, with the current focus on coverage for preexisting conditions, has drawn a great deal of attention to the concept of health insurance. While our political leaders are constantly talking about it, few of them seem to understand the “insurance” component of health insurance. As a result, much of what they say about preexisting condition coverage is gibberish. We are here to set the record straight.
At its most basic level, insurance provides protection against the risk of unexpected financial losses. We focus on the term risk because if we were risk neutral (i.e., we were indifferent between sure things and actuarially equivalent gambles), then we would not value this protection. But nearly all of us are risk averse, meaning that we would rather not face having to dramatically reduce consumption of everything we enjoy in the event we are hit with an astronomical medical bill. Because we are risk averse, health insurance improves our collective well-being by helping us collectively smooth our consumption. Everyone who purchases insurance consumes somewhat less of everything else when healthy, but does not have to consume dramatically less when sick.
Turning to preexisting conditions, consider a person who is currently uninsured but has recently been diagnosed with a serious medical problem. Given the opportunity, this person would love to purchase a health insurance policy. But make no mistake about it, this policy is no longer insurance in any traditional sense of the term. By skipping out on paying premiums until the illness strikes, this individual has consumed a lot more than everyone else when healthy, yet is able to consume almost the same as everyone else when sick (almost because there is likely to be some cost sharing). This isn’t consumption smoothing, it is free riding, and this is what the prohibition on considering preexisting conditions encourages.
(To be fair, some individuals may lack the means to purchase insurance at any price, even with ACA subsidies, and it is excessively harsh to describe them as free riders. We will return to these cash-constrained individuals at the end of this blog.)
There are two problems with free riders. First, someone has to bear the cost – that someone is the “responsible” (although some might say “foolish”) individual who purchased insurance all along. Second, because free riding drives up the price of insurance for everyone, some responsible individuals refrain from buying insurance in the first place, potentially even leading to a death spiral.
To help make things clear, we have constructed a simple numerical example. Suppose there are 100 people who each have a 20 percent chance of incurring a $50,000 medical bill at some point in the next five years. If everyone purchases insurance, premiums would be $10,000 each year. But suppose that only 70 people buy insurance every year, while 30 people free ride, purchasing insurance only at the time they require medical care. In expectation, 20 people will be sick each year, 14 “responsible” individuals and 6 free riders. With an annual insurance pool of 76 enrollees (the 70 responsible ones and the 6 free riders), the insurer would have to charge a premium of $13,158. This is quite a good deal for the free rider, who otherwise would have had to come up with $50,000 (or paid over $13,000 in premiums each year).
This table summarizes the conclusions:
If insurers could discriminate based on preexisting conditions, they certainly would not issue a policy to someone requiring $50,000 of medical care for any less than $50,000 in premiums. But prohibited from discriminating, insurers must “over-charge” responsible customers in each year to make up for the shortfall of having to cover the free riders. The amount of the overcharge is not small, and the increased premiums may well scare additional people out of the market.
It is remarkable to us that seemingly the only feature of the ACA with broad appeal is the provision that bans insurers from considering health status when offering and pricing insurance plans. The purported purpose of this ban is to assure that all individuals have access to insurance, but that clearly is not the true effect. Instead, the effect is to encourage free riding while punishing those who do the “responsible” thing. It is for this reason that the ACA contains both a mandate (which given its size is of dubious effectiveness) and pre-specific annual periods of open enrollment (i.e. you can only purchase insurance, barring extraordinary circumstances, during a pre-specified time of the year). These are the provisions that are under attack, yet these are what make the ban on preexisting condition exclusions almost sensible. Our politicians have it ass backwards. If anything, we should be increasing the cost of the mandate to discourage free-riding.
One possible solution to the free-riding problem would be to not provide coverage to those who game the system and/or gamble on their health status. However, there is a reasonable argument made that as a society we do not want anyone to face high medical bills, and potentially even medical bankruptcy, even if they knowingly chose to free ride. This sentiment certainly underlies existing arguments that even those who have been diagnosed with cancer or who are currently pregnant should be allowed to purchase “insurance” in the marketplaces. Is there a national consensus about this? We are not sure. Should there be a two-tiered system, so that those who knowingly free ride are forced to obtain care at “lower quality” providers (perhaps some county hospitals fit the bill)? We are not sure of this either. Is anyone asking these hard questions besides us? We are sure they are not.
The remaining question then is how we fund the redistribution system that we have created. In the terms of the simple numerical example above, we fund the $50,000 in medical expenditures for the free-rider by charging higher premiums to the responsible customers that purchase insurance when they are healthy. This is similar to what happens in the ACA. These higher premiums are paid for through two primary mechanisms. For the subsidized portion of the marketplace, the increased premiums are paid via general tax revenue. However, the unsubsidized portion of the market (those earning more than 400 percent of the poverty line) are forced to pay for both the portion of the premium that relates to their risk of medical expenditures as well as pay what is effectively a tax to support individuals who chose not to purchase insurance until they were sick.
This is terribly unfair. The ACA marketplace is a small sliver of the total insurance market and as a result we are asking quite a bit of the higher income marketplace enrollees (who are not necessarily high income in the broader population). In the process, we are driving the healthiest of these individuals out of the marketplace. They either will seek employer based options or go without insurance. And why wouldn’t they leave? They have the ability to eventually enter the market if they get sick. Note that these healthy and higher income enrollees are the very people who have failed to show up to the ACA marketplaces in the numbers that we expected. Given the discussion above, this should perhaps not be surprising. We are placing a fairly high premium tax on those individuals.
Having hopefully convinced you that funding the redistributive portion of the ACA via premiums is distortionary and inefficient, we next turn to possible solutions. Like many things in healthcare, while the problem here is clear that answers are far less so. One potential solution is to create a series of heavily subsidized insurance pools for individuals who have known high medical expenditures and have chosen to previously forgo the purchase of insurance. These are often referred to as “high risk” pools, which is itself a bit of a misnomer. There is no risk here; these are high cost pools where we know individuals will have high medical expenditures. An advantage of such a strategy is that funding these pools via general tax revenue instead of premiums wouldn’t distort the insurance decisions of healthy high income exchange enrollees. However, putting individuals into a high risk pool doesn’t decrease their medical expenditures and therefore these pools have to be heavily subsidized. The sheer size of these subsidies is often daunting and faces political opposition. Underfunded high risk pools are certainly not a good solution – and for this reason ACA supporters are often unimpressed by this as a solution to rising premiums.
Another solution is simply to reinsure firms that offer insurance from the federal marketplace. Effectively, for expenditures over a certain threshold the federal government could agree to compensate insurers. In some ways this is the idea behind the “invisible high risk pools” that have been recently debated. Again, reinsurance involves observable transfer payments to private firms – something that while potentially efficient has drawn political ire (remember the billions in risk corridor payments the government didn’t ultimately pay insurers). This seems to have little support from the public, who view this as a subsidy to insurers (though only to make sure they don’t lose money), rather than a way to stop taxing responsible exchange enrollees.
We would note for the purposes of completeness that another (perhaps less equitable) option would be one we discussed earlier. Allow everyone a few years to buy their way into the insurance market regardless of their current health status, and then reintroduce medical underwriting. People who choose not to participate in this market would then be allowed to receive medical care at county hospitals which would receive increased funds to cover the costs of these individuals. These funds could come from general tax dollars. We note that this to a first approximation, this system is not that meaningfully different from the current standard.
As a final note, if we want to have serious conversations about the role of preexisting conditions and the choice to purchase insurance we need to make sure that individuals are not liquidity constrained from buying coverage in the first place. For example, individuals earning less than 100 percent of the poverty line and living in the 19 states which did not expand Medicaid are effectively locked out of the insurance market because of their lack of resources. We shouldn’t see this as an expression of their preference to be uninsured or evidence of free riding.
While we both have over time been critical of various features of the ACA, one feature we have consistently praised is the creation of a viable non-employer based option for individual insurance. The first three years of the ACA have shown that the marketplaces have failed to live up to these expectations. Insurers have consistently claimed that individuals are gaming the system in a manner that is similar to the numerical example that we discuss above. The resulting higher premiums are likely a driving force in the inability of these markets to attract higher income and healthy enrollees – who are necessary for a well-functioning insurance market. For this reason, we would call on policymakers to carefully consider changes to the ACA that would improve the redistributive portions of the law.
David Dranove and Craig Garthwaite are economists at the Kellog School of Management at Northwestern University.