Monday, November 2, 2009

Insurance companies don't have to be "bad" for the public option to be good

insurance companies

SOME, including President Obama, have said that a public health-insurance option is necessary to "keep insurance companies honest." However, there's no need to imply that private insurance companies are dishonest. Rather, they're simply not designed to provide the type of low-cost, universal access to basic health-care services that America desperately needs.

Why? Well, there are two fundamental economic problems in the private health-insurance market. The first is overconsumption. A few decades ago, American businesses found out the hard way that by paying their employees' health-care bills, they inadvertently shielded their workers from bearing the associated costs. Employees inevitably ended up consuming too much and health-care expenses spiraled. In fact, the U.S. managed-care industry grew out of employers' attempts to tackle this overconsumption problem.

The second problem is what economists refer to as "adverse selection." While the concept originated in an insight about the used-car market, it is now a fundamental pillar of insurance economics. The idea is simple: Markets work badly whenever sellers know more than buyers (or vice versa).

Consider the plight of used-car buyers, for example. If they offer an "average" price for what they expect is an average-quality car, they'll inevitably overpay. This is because higher-quality car owners will refuse to sell, while lower-quality owners will gladly accept. If buyers lower their offer, even more high-quality car owners will refuse to sell, leading to a vicious cycle.

Economically speaking, the private-insurance market functions just like the market for used cars — and I'm sorry to say consumers are in the position of used-car dealers. That's because individuals know the most about their own health. If insurers set premiums high enough to cover costs for people with "average" health, healthier people will not enroll, while sicker people will find insurance a great deal. Left unchecked, this dynamic leads to ever-rising premiums as healthier people drop out of the market and only sicker people remain.

Private insurance companies, at core, are businesses designed to tackle these economic problems of overconsumption and adverse selection. To limit the former, they invest in restricting access to health-care services — for example, by requiring prior authorization for a number of procedures, refusing to cover others, and setting lifetime limits on benefits received. To tackle the latter, they refuse to cover "pre-existing conditions" and spend enormous sums screening potential customers in an attempt to deny coverage to those most likely to get sick.

It is these activities — not excess executive compensation, dividends, or "marketing" — that eat up between 20 to 30 cents of every dollar in premiums they receive. It is also these activities for which insurance companies are frequently criticized.

Are insurance companies wrong to engage in these practices? Well, as profit-seeking enterprises, the cold logic of the market requires them to do so. Unfortunately, the result is a huge population of uninsured Americans whose only recourse is to seek late-stage and emergency-room care, which contributes to the out-of-control health-care costs that are threatening our economy.

Fortunately, most agree this cycle can be halted with policies that guarantee access to essential health-care services for every American. There is sharp disagreement, however, about who should provide the type of low-cost universal insurance that is required.

While emotions run strong on both sides of the public-option debate, the economics are straightforward. Private, for-profit insurance companies are simply not designed or equipped to provide the type of low-cost universal coverage America desperately needs.

Could private insurers adapt their business models to serve this new market? I would certainly expect so, given the right competition. But without the competition a public option will provide, I wouldn't bet a trillion dollars on it — which is exactly what insurance companies are asking us to do.