Repeal + Replace

Not Really Insurance: The Pre-Existing Condition Debate

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.

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RemarkljPatrick ShannonPeterJason ChungJwood Recent comment authors
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Remarklj
Member
Remarklj

Is it insurance? Yes, but… Health insurance policies are set up as “claims-made” policies; whoever is your insurer when you go to the doctor pays your bills. But the insurable event for health insurance purposes is getting sick, not getting treatment. The argument over pre-existing conditions stems from this simple misunderstanding of what, exactly, we are insuring against. The key to solving the pre-existing condition problem is to restructure private policies as “occurrence” policies under which the company insuring you when you get sick pays your bills. How might that work for people who change insurers? Well, Medicare’s DRG technology… Read more »

Patrick Shannon
Member

The pre-existing condition problem was not so much about uninsured people buying insurance but people being denied insurance because of some illness that they had had in the past (defined as a “condition”) that they no longer had. In the individual market, where people were still medically underwritten, this was a problem. Also a problem is that people would either be terminated after a renewal or would be given a premium increase that was so high at renewal they had to drop the policy. And they would then be unable to get one at another carrier because of their pre-existing… Read more »

jamesepurcell
Member

What we have here is rampant excusal for bad decisions. I won’t say stupidity. People must be insured. If they choose not to be, there are consequences. It’s rather simple.

Peter
Member
Peter

The author left out a a solution – increase the size of the pool and therefore spread the risk over a larger field which would be much less of a burden on all premium payers.

That solution is Medicare for all – a pool of 300 million people.

Jason Chung
Member

Thank you for this article. The authors make an elegant point about the necessity of the individual mandate. Of course, this begs the question of as to why, if mandates are designed to increase participation and smooth out collective consumption costs, we aren’t looking harder at mandatory single-payer health insurance, funded directly through taxes, for baseline services and care (much as Jwood notes). Even go-to bastions of free market principles, like Hong Kong (where I worked for a short while), have a well-funded public health care system through government-run hospitals. Those with sufficient funds trade health care for cost while… Read more »

BobbyGvegas
Member

The GOP is now under the control of a faction that denies the very legitimacy of a “commonwealth,” a society with ANY aggregate moral obligations to one another. Humans exist to serve the “market,” not the other way around.

Though, it must be noted, those of them in Congress will most certainly continue to avail themselves of their 70% taxpayer-subsidized health plan premiums under FEHB.

Allan
Member
Allan

The alternate view is that Democrats view human citizens as slaves of the state.

Jason Chung
Member

Allan, I have to say that I don’t view pooling wealth via taxation for the exchange of life-saving services to be an example of state-sanctioned serfdom. In fact, I’d argue that it’s really the core of what a successful state should provide in exchange for our taxes. Bobby, I agree with your assessment of the current political climate. Generally, I’m not in favor of a technocracy but I do think it’s important for those in public service to remember what the government does well by design – provide baseline services for the benefit of the whole population including vulnerable and… Read more »

Allan
Member
Allan

“Allan, I have to say that I don’t view pooling wealth via taxation for the exchange of life-saving services to be an example of state-sanctioned serfdom.” It is not a matter of what you think rather a matter of political philosophy. I believe in individual freedom and the Constitution. You are free to believe and think whatever you want. You can even believe the state has the right to force the individual to spend money enriching private entities and private individuals. The question is where does that type of logic stop? Some people actually believe that Cuba has a great… Read more »

Allan
Member
Allan

Jason, I think I should touch on your point to Bobby. Do you believe in single payer or Medicare for all? If you do then you have a model that already exists. How would you reform the Medicare model to make it sustainable? Alternatively, are you thinking of a Medicaid for all model which is more likely to develop from the Medicare for all model? How do you make either of these ideas sustainable? Jason, I should add that we are both looking for the same results. Good healthcare, affordable cost and reasonable access to healthcare for all. I simply… Read more »

Jason Chung
Member

Allan, I agree we have the same goals so I’m delighted to continue a dialogue. I simply do not share your view that taxation for services is necessarily socialist or that, even if you classify it as so, it’s necessarily a bad thing. Let me explain my reasoning. As we agree on some governmental intervention in healthcare markets, I think we’re discussing the merits and cons of degrees of intervention which is a nice place to start. In my view, there is a central practical problem that impede a truly free market when it comes to taking a contractual view… Read more »

Allan
Member
Allan

Jason, I’m glad that you are willing to talk things through in a rational manner. That is refreshing. I understand your desire to level the playing field something that I strongly agree with. That is something that government sometimes has to be involved in, but generally something that can be managed in a contractural basis. For now I will leave out Constitutional considerations along with the long time protection of a stable government that requires a Constitution with teeth whether or not we agree with the law, That is why we have an amendment process. I will also temporarily leave… Read more »

Jason Chung
Member

Allan, thank you for your thoughts. I look forward to reading them in greater detail this afternoon.

Have a safe flight and I look forward to discussing further either here or via e-mail. I’m reachable at jason.chung[at]nyu.edu.

Peter
Member
Peter

Allan, you’re free to not participate in the slavery of Medicare you now enjoy.

Allan
Member
Allan

Peter. that is not true. You are like the thief in the night that says your life or your wallet.

Jwood
Member
Jwood

Thanks for explaining, good article. I’d like to know an economists perspective how quality plays into the economics of health care delivery? The way I see it, since we can’t discriminate on quality with health care this is the biggest problem in trying to subsidize it or give it away “for free”. My idea is to convert the current VA system into the “basic” government plan that may end up being lower quality, but would cover all. Then, you could have no pre-ex because there could never be a situation where someone does not maintain continuous coverage. All of these… Read more »

Allan
Member
Allan

When working to reduce costs one of the first things that should be addressed is marginal care. Marginal care leads to large expenses for little or no benefit. The problem is that too many complain that consumerism doesn’t change the amount of marginal care with the rational argument that no one can know for sure when the care will prove to be marginal. At the same time another or the same person will point to medical care that they believe is marginal care even though they can’t be sure of that either. A lot of marginal care is in a… Read more »

Steve2
Member
Steve2

“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.”

That is their history. They were underfunded in most states, and so expensive in some that they were not affordable. Also, IIRC, a majority of them or at least a large minority had a 6-12 month waiting period until pre-existing conditions were covered.

Steve

jamesepurcell
Member

David and Craig: Outstanding article. It is astonishing how little politicians and even most “advisors” know about the basics of health insurance. The pre-ex is just one such item. David, I know you know about Rhode Island. As I recall, my former law firm hired you as an expert in a healthcare anti-trust matter while I was running BCBSRI. In RI, BCBSRI voluntarily stopped using a pre-ex in the 90’s. It just plain got to be too much trouble, spawning litigation and bad press; and the pain wasn’t worth it. Instead we used a limited open enrollment period with medical… Read more »

Barry Carol
Member
Barry Carol

The service utilization problem may be on the way to partly resolving itself. The incidence of smoking in the U.S. is down drastically from 30-40 years ago thanks, in part, to high cigarette taxes. Soda consumption seems to be in secular decline, organic food is on the rise, and so is prepared food with fresh ingredients at the expense of less healthy packaged foods. I have no idea how long these positive trends should take to show up in improved population health to drive down per capita utilization of healthcare services. It is unfortunate that obesity rates in the U.S.… Read more »

Paul @ Pivot ConsultingLLC
Member

Re: ” Claims expense is driven by rates of use of services.” Agreed, and mostly agree with your 4 points. But this list misses a key element: the rates of use of services is hugely wasteful, as too many services provide no benefit, marginal benefit and even harm. Rand estimates 30%, Nortin Hadler estimates up to 50%. Patients are by and large checked out, as many pay little or nothing and they assume if the doc/hospital system suggests a test or procedure it is a signal of benevolent caring…..alas, that too often is not the case.

jamesepurcell
Member

A close relative went through surgery and a hospital stay. The waste is enormous. I had hopes that EMRs would dent that, but alas, it seems not. I agree Paul. The definition of “waste” is elusive, but I think we all know that of the 30%, at least half could be eliminated.

Steve2
Member
Steve2

I suspect that most of that 30% is tied in with what we decide to do and not so much how we do it. We know that a lot of surgeries, since that is what you mentioned, should never be done to begin with. We also know that the more expensive alternative is also frequently chosen when there is a less expensive option that has comparable results. My direct experience is that a lot of the wasteful testing and lengthy stays we used to have are disappearing, though we still have a way to go. On the insurance side, it… Read more »

jamesepurcell
Member

Steve, I totally agree that it is all about what insurers whil reimburse you for. Totally.

Barry Carol
Member
Barry Carol

I have no idea about the extent to which so-called waste can be identified in real time even by doctors and, if it can, how much of it is really either defensive medicine or intended to increase revenue or both in which case there is no incentive for doctors or hospitals to eliminate it and it would be hard for the patient to decline it even if he wanted to.

jamesepurcell
Member

Oh, one other thing. How the hell does a patient know if something is wasteful or not? When you are in the hospital, you haven’t a clue and you’re drugged, and fearful. No amount of consumerism changes that (a new perspective I’ve gained).

pheski
Member

I think I missed the paragraph where the authors mention that a simple way to prevent the free-rider problem is to require (mandate) participation. If we are going to act under the assumption that everyone has a right to health care, then it seems to me we should act under the assumption that everyone is required to participate in the financing of health care. I don’t get to claim that I am a pacifist, that I don’t want to participate in supporting war machinery, and that therefore I don’t have to pay taxes for that. Or that I don’t drive… Read more »

BobbyGvegas
Member

Where’s the dad-gumbed “like” icon?

Barry Carol
Member
Barry Carol

It’s unfortunate that the history of high risk pools prior to the ACA is abysmal. Politicians viewed their cost as too much money to spend on two few people many of whom are too sick to even vote and there are lots of other worthwhile priorities, both public and private that need and deserve funding. I’m most attracted to the idea of reinsurance partly because the cost is less visible to the individuals who ultimately benefit from access to health insurance that they wouldn’t otherwise be able to access. Setting the attachment point beyond which reinsurance would kick in is,… Read more »

BobbyGvegas
Member

I get your broad point, but, a question regarding your math:

“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…”

At some point in the NEXT 5 YEARS?

Followed by

“In expectation, 20 people will be sick each year…”

So, “20% EACH year” will (randomly?) be afflicted (as you’ve stated), or once across the 5 year frame of your proffered model?

Which is it? I’m having a recursive summational “contingent probability” problem here. I’m just dense today.

BobbyGvegas
Member

Stated in the alternative (1-p), if I have an 80% chance of NOT have a $50k UTIL each year, then my summary 5-yr “conjunctive probability” of going 5 years without a problem is 0.8^5 = 0.327 (~33%).

This is just a variant of the sequential “fair coin toss” stuff (independent events).

Saying “20% over 5 years” seems to not equate to “20% per year.”

On a lighter note, I once wrote and recorded a song about “Free Riders.”

https://www.youtube.com/watch?v=gR-w9LLpieM