Community Rating – The Worst Possible Way To Do a Good Thing

By SAURABH JHA, MD

I have a grudging respect for health economists, “grudging” because, like many doctors, I want my pieties unchecked. Health economists check our pieties with quantitative truths. They describe the way the healthcare world is – a view from 29, 000 feet, pour cold water on the way we think the world should be, and guide, with abundant disclaimers, the way we can make things better. It’s unwise climbing Everest without a Sherpa, nor is it wise reforming healthcare without listening to health economists from across the political spectrum.

President Trump, along with the Republican House and Senate, will be dismantling the Affordable Care Act (ACA). In a sense, President Trump is not just descending Everest, a treacherous feat in its own right, but scaling a peak arguably more dangerous than Everest. Despite their differences, Mr. Obama and Mr. Trump share one commonality – an implicit distrust of the health insurance industry.

How did the American health insurance industry become so vilified? This is, in part, because necessity is the father of all vilification. Insurers are a necessary evil in a country where there’s still deep mistrust of the government. Partly, this is because we transfer our angst about the uncertainty of our future, the dice which plays with our lives, to insurers who are in the business of rolling the dice. But mostly it’s because the misdeeds of the insurance market have been grossly exaggerated, and the benefits of the market have been attenuated by a few damning anecdotes. This is what Mark V. Pauly (MVP), Professor of Health Economics at the University of Pennsylvania, and one of the most eminent health economists of his generation, believes.

Informed by his research, Pauly is a rare defender of the insurance industry in academia. I recall attending a class by Pauly a few years ago. Two things struck me about the soft-spoken economist. The first was his reluctance to prescribe solutions without explaining the tradeoffs. Pauly is unlikely to appeal to demagogues or policy makers seeking inexpensive balms for complex problems. The second was his penchant for stating the counterintuitive. I met Pauly on a rainy day in Philadelphia in the Library Bar at the Inn at Penn. I remembered from my class how painful ignorance can be when speaking to Pauly. So, I read up as much as I could during the New Year’s weekend. It didn’t help much. I was still beseeched by facts unbeknownst to me.

The Interview

SJ: The insurance industry is demonized by everyone, particularly doctors. You have a more favorable view of the industry. You believe that it can be a force for good if appropriately managed. I want to get to the heart of the distrust. Is it because we haven’t gotten over Akerloff’s “The Market for Lemons?”

MVP: Let’s back up. The lemons problem, described by George Akerloff, is related to the used car market because of asymmetric information. The sellers know more about the quality of the car than the buyers, and because of that the buyers will underprice the high quality cars, which the sellers will remove because they’re underpriced, and the market will be full of low quality cars. The analogy with healthcare is partial. Buyers of health insurance do know more about their health status than sellers – to be clear, this is relevant in the individual market (IM), not employer sponsored insurance (ESI). Regardless, asymmetric information is not unique to healthcare. For example, drivers know much more about their driving abilities than sellers of car insurance. The insurance for automobile collision hasn’t gone into a death spiral.

However, the information can be symmetric. The sellers of health insurance can roughly risk rate the buyers by asking questions about their health, recent visits to doctors, family history and tobacco and alcohol use. What historically led to adverse selection – the sick disproportionately purchasing health insurance – wasn’t the lemons problem per se but that insurers weren’t allowed to risk rate.

SJ: That’s an early counterintuitive fact. What you’re saying is that community rating – charging everyone the same premium regardless of their risk is what led to adverse selection. If I may restate, community rating made it more likely that sick, rather than healthy people, purchased insurance. Or to put it bluntly, the prescription to prevent adverse selection caused adverse selection. This was a policy own goal. I must admit it doesn’t make sense.

MVP: The reason it doesn’t make sense is because we forget there are tradeoffs. So, when you prevent the insurer from risk rating what do they do?

SJ: They raise the premiums for everyone to compensate.

MVP: What effect does that have?

SJ: It makes insurance more expensive for the healthy.

MVP: Sure, but what effect does that have?

SJ: The healthy are less likely to buy insurance.

MVP: Right. And not just that, people with co-morbidities are more likely to buy insurance. You can see that community rating entices the high-risk and discourages the low-risk. What’s that called?

SJ: Adverse selection.

MVP: And in the IM, it’s more significant than people think. We found that when insurers changed to community rating, while the probability that the high-risk were covered increased, it was overwhelmed by the probability that the low-risk, the healthy, didn’t buy insurance. This is not good for the IM. Another example I have – one of my PhD students has studied the Medigap insurance. She found that adverse selection is greater when there’s community rating than risk rating.

Insurers are good at risk rating. The only thing they miss is when a couple is planning to start a family. As you can imagine, the intent for pregnancy can’t be captured in a questionnaire – you can plausibly deny it. Aside from that, insurers can adequately risk rate – so the lemons problem in healthcare is contrived.

SJ: I can see how one can be poetic with the truth with pregnancy. But this does mean that you endorse risk rating. This means that the sick pay more, a lot more. My residual liberal sentiments can’t abide that. What’s your prescription so that the high-risk aren’t financially fleeced?

MVP: If insurers are permitted to risk rate, the premiums for the healthy will fall and more healthy people will voluntarily buy insurance – let’s agree that’s a healthy outcome. The premiums for the high-risk will surely rise. My proposal– let the insurers risk rate but let us subsidize the premiums for the high-risk.

Money must come from somewhere. What is happening now is that the low-risk are subsidizing the high-risk. Make no mistake – this is a transfer of wealth, but not a very equitable transfer of wealth. In essence, community rating is an excise tax on the low-risk.

SJ: You just used the “T” word which, politically, is more offensive than the “F” word. It seems that you don’t want the high-risk to be thrown under the bus. What you’re suggesting is that the high-risk should be subsidized explicitly by general taxation.

MVP: Taxation is a political problem. Politicians favor hidden taxes over explicit taxes – excise tax on the low-risk, imposed by community rating, is not counted as tax and does not show up on the budget. Even the low-risks are likely to blame the insurers, not the regulators, for the high premiums. The high-risk should be helped by general taxes. The market can’t function without taxation of some form.

SJ: A related question – how significant is the problem of high-risk purchasing insurance in the individual market?

MVP: The numbers quoted about the prevalence of high-risk vary and some say it’s as low as 1 %, but I believe a more correct number is 4 %.

SJ: Many believe that the problem of pre-existing conditions is much higher – around 30 %.

MVP: Most people can’t be “high-risk”, most must be average or below-average risk, unless the country is a perverse Lake Wobegon, where everyone is above-average. This is common sense. In fact, the distribution of risk is skewed to the right, meaning that the average is driven by relatively few high-risks. The probability that someone becomes high-risk precisely when they buy insurance should be even lower than the prevalence of the high-risk – this is simple probability. Yes, we are still talking about many thousands of people and we must help these people, but you do not need drastic changes in the market and heavy regulations to help this small group. Specialized interventions targeted at the small minority of high-risk would be more efficient, more transparent and more feasible.

SJ: Does what you’ve just said not contradict the 80:20 rule – that 80 % of healthcare costs are incurred by 20 % of people? Surely, the high-risk must be at least 20 %.

MVP: Ok, I can see the confusion.

Let’s first define “risk” in insurance parlance. Risk is the expected medical spending. High-risk have a higher expected medical spending and the low-risk have a lower expected medical spending.

The confusion lies in the definition of high-risk. By high-risk, I do not mean low-risk people who have a medical event and then become a higher risk. I mean people who are high-risk when they first purchase insurance – the former is far more common than the latter and is often mistaken for the latter.

Though there are some real cases where insurers misbehave with the low-risk who become high-risk, by dropping coverage, this problem has been exaggerated and can be easily mitigated by guaranteed renewability, which was a common feature in the IM even before it became mandated by regulations.

Thus, the common misunderstanding leads to confusion about the 80-20 rule which is that 80 % of healthcare spending is on 20 % of the population. We confuse this for the magnitude of the problem of the high-risk. Rather, this number refers to the spending distribution of the low-risk who become high-risk in their lifetime. It’s important to maintain this distinction. The major purpose of insurance is financial protection for uncertain events – i.e. the low-risk turning to high-risk. Insurance achieves this by pooling risk, and pooling risk means pooling the people who have similar risks of an uncertain future. Pooling risk pools the unknown. Pooling risk does not work if you pool people with a known future (high-risk) with people with an uncertain future (low-risk).

To emphasize, there are truly more low-risks and fewer high-risks than suggested by the 80-20 rule. This rule merely tells you that even if you start off with a group of people with same (low) risk, the future spending is unevenly distributed.

SJ: This is a very nuanced distinction and I can see how unfettered zeal can conflate the two groups of risk. If I may summarize. What you’re saying is that the market should be allowed to work with risk – the known unknowns (to borrow a Rumsfeldian aphorism) – and the government should help with certainty, the high risk, the known knowns.

I’m going to bring up another point you mentioned in our class, something which stuck with me – see I was paying attention! You said that one of the reasons entities don’t discriminate, and I think you were quoting Milton Friedman, is that the costs of obtaining information to discriminate are so prohibitive that the benefits of discrimination aren’t worth the transaction costs of getting the information to discriminate. Surely, the insurers can’t actuarially price (perfectly risk rate) the high-risk even if they wanted to.

MVP: No they can’t perfectly risk rate, that’s correct. I did a study with David Asch where we asked insurers if they would use genetic information if available. Most said they won’t. Why do you think that is?

SJ: Well, it’s not from the goodness of their hearts. I suspect the added information has diminishing returns.

MVP: That’s certainly one reason. Insurers don’t feel that genetic information adds much more to family history, and it’s easy getting family history. The other reason is that insurers feel that if they mandated genetic testing, people would be even less inclined to buy insurance. Remember, insurers need people buying insurance to survive.

SJ: So, in the individual market there’s a tradeoff between healthy voluntarily buying insurance and community rating?

MVP: Yes, there’s a tradeoff – community rating in the individual market increased premiums making it less likely that healthy purchased insurance, and more likely that the high-risk bought insurance, but the net effect, and this has been empirically shown repeatedly, is that the net uninsured increased.

Once you started community ratings you ran into other problems. Insurers avoided or underserved high-risks.  Insurers tried gaming the system with clever insurance design and regulators responded with more regulations. Rules were put in place to risk-adjust revenues insurers collected. Risk adjustments are imperfect. One bad policy led to several regulations.

SJ: This sounds like some game theory going on, like a game of chicken, or something, between insurers and regulators. And we threw bad regulations to chase bad regulations.

You once said that blaming the individual market for high premiums is like blaming Cinderella for poor fashion. Two questions. Why, other than community rating, is the premium so high in the individual market? And does that mean ESI is one of the ugly stepsisters?

MVP: The premiums are high for many reasons. The administrative costs in the individual market are high. I did the calculations once. The administrative costs, as a percentage of claims, are 27 % for group size of 1-20, 12 % for group size of 100-500 and 4-6 % for group size exceeding 10, 000. This is partly because the selling costs for insurance in the individual market are high.

But taking the Cinderella analogy further, the ESI is like a spoilt stepsister because of the tax subsidies. My wife and I receive a tax subsidy of $10, 000, and my administrative assistant, in a much lower income bracket, doesn’t have the same luxury. This is moral inversion. The tax subsidy for ESI is regressive taxation. The individual market can’t compete with that.

Although politically unpopular, the tax subsidies of the ESI should be abolished to level the playing field. I think it’ll make some people choose insurance from the individual market, but overall I don’t think the ESI will be destabilized.

SJ: Continuing with the Cinderella analogy, Cinderella had many redeeming qualities (not related to fashion). Does the individual market have redeeming qualities?

MVP: First, I must emphasize that the markets for insurance for non-poor are easy to mess up.

The individual market can have many redeeming features. For one, there is choice about the level of coverage, what’s covered and the amount of deductible one has to pay. Not everyone has the same preferences for these. Once the insurer set a premium, as long as the premiums were paid regularly, the insurer didn’t increase the premium just because the risk profile changed because of a new disorder. This feature is known as “guaranteed renewability.”

SJ: Can you expand on the second point?

MVP: “Risk reclassification” is when the low-risk have an unexpected medical event changing their risk profile. What then happens is that the insurer drops coverage or raises their premium. The risk of risk reclassification is when there is annual risk-rating of health insurance. Fortunately, most insurers in the individual market before the ACA avoided this problem by “guaranteed renewability” where the insurer didn’t raise the premiums of people who started and remained with the individual market so long, as they kept paying their premiums.

Paradoxically, those at-risk of risk reclassification were people who lost their employer-based coverage and moved to the individual market as high-risks. Even more paradoxically, it was the insurers in the individual market who were blamed for not picking up the slack, rather than the job-based insurers for creating the slack.

The knee jerk policy reaction to risk-reclassification has been community rating which, as I’ve alluded to, is the worst possible way to do a good thing. A better policy prescription, which I believe is in the Ryan plan, is to allow people who leave the employer market to the individual market, to carry their premiums with them.

About the Author

Saurabh Jha is a radiologist and contributing editor to THCB. He knows far less about economics than he thinks he knows, and he thinks he knows far too little. He can be reached on Twitter @RogueRad