How The Free Market Fails At Health Insurance

or, Why Universal Health Insurance Coverage Is Not (Necessarily) A Liberal Entitlement Program

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THE INVISIBLE HAND of the free market works quite well for most traded goods and services. But health insurance is a unique situation, and there are unique reasons why the free market fails with it. These reasons have nothing to do with the way most people frame the issue, around rights and duties to our fellow humans and the morality of providing health services to those who would have trouble affording them.

Health care cannot be a right, as some say. I don’t think you can call anything a right that must be provided by one person for another, as health care is. Just because someone has studied and worked to become a doctor doesn’t give any other person a right to their services. That doctor is still a free individual. And while some would call it a moral failure when essential things like food or medical services are provided only to the rich and not to the poor, or when the rich get rich beyond all proportion, that’s not really a market failure in and of itself. The market is supposed to provide more to those who are able to produce more.

The way the free market fails in health insurance centers around a problem unique to it, the grouping problem. And though it is the central issue in the debate, it is little discussed. But it’s really not hard to understand.

The two main points of the grouping problem are 1) how any health insurance free market inevitably excludes some people arbitrarily and 2) why you cannot force health insurers to provide coverage for anyone who wants it without also forcing all individuals to buy health insurance (the so-called individual mandate). I’ll explain some other things as well, such as why the grouping problem is unique to health insurance in comparison to other types of insurance, and the difference between the price and the cost of health care, but these two are the essentials.

In the end, the answer of whether to adopt a health insurance free market or a universal health care scheme is not clear cut, as there are some serious downsides to universal health care that must be acknowledged. I discuss them in this post here.

But read the following first. It provides the foundational points for understanding health insurance.

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How The Free Market Fails At Health Insurance

TO GET STARTED, I’ll quote the writer from whom I first gained an understanding of this issue, economist Charles Wheelen, from his book Naked Economics:

Insurance is about getting the numbers right. Some individuals require virtually no health care. Others may have chronic diseases that require hundreds of thousands of dollars of treatment. The insurance company makes a profit by determining the average cost of treatment for all of its policyholders and then charging slightly more. When Aetna writes a group policy for twenty thousand fifty-year-old men, and the average cost of health care for a fifty-year-old man is $1250 a year, then presumably the company can set the annual premium at $1300 and make $50—on average—for each policy underwritten. Aetna will make money on some policies and lose money on others, but overall the company will come out ahead—if the numbers are right.

Let me first pause here for a moment and remind everyone that an insurance company like Aetna has to make a profit, and that their making a profit is in no way immoral. Insurance companies wouldn’t exist in the first place unless they provided a return on investment versus level of risk that was competitive, not just with other insurance companies, but with all other things in which to invest, including real estate, Google, and gold, because no one would put capital in the businesses if they weren’t. Aetna is a publicly traded company, meaning many individuals own shares in the company, including probably many retirement funds, including possibly you. You can’t judge an insurance company for “making profits off of sick people” unless you yourself never try to put your money into profitable investments, as that would just be telling other people what to do with their money while retaining the freedom to do as you will with your own. That is a deep hypocrisy.

Okay, so we have a $1300 policy Aetna is selling to fifty-year-old men, and with the average annual cost of health care for these men being $1250 (with some of these men using much less than $1250 worth of health care services each year, and some of them using much more), Aetna makes $50 a year on each policy. Everyone wins. But…

The $1,300 policy is a bad deal for the healthiest fifty-year-old men and a very good deal for the overweight smokers with a family history of heart disease. So, the healthiest men are more likely to opt out of the program; the sickest guys are more likely to opt in. As that happens, the population of men on which the original premium was based begins to change; on average, the remaining men are less healthy. The insurance company studies its new pool of middle-aged men and reckons that the annual premium must be raised to $1,800 in order to make a profit. Do you see where this is going? At the new price, more men—the most healthy of the unhealthy—decide that the policy is a bad deal, so they opt out. The sickest guys cling to their policies as tightly as their disease-addled bodies will allow. Once again the pool changes and now even $1,800 does not cover the cost of insuring the men who sign up for the program. In theory, this adverse selection could go on until the market for health insurance fails entirely.

That does not actually happen. Insurance companies usually insure large groups whose individuals are not allowed to select in or out. If Aetna writes policies for all General Motors employees, for example, then there will be no adverse selection. The policy comes with the job, and all workers, healthy and unhealthy, are covered. They have no choice. Aetna can calculate the average cost of care for this large pool of men and women and then charge a premium sufficient to make a profit.

Writing policies for individuals, however, is a much scarier undertaking. Companies rightfully fear that the people who have the most demand for health coverage (or life insurance) are those who need it most. This will be true no matter how much an insurance company charges for its policies. At any given price—even $5,000 a month—the individuals who expect their medical costs to be higher than the cost of the policy will be the most likely to sign up. Of course, the insurance companies have some tricks of their own, such as refusing coverage to individuals who are sick or likely to become sick in the future. This is often viewed as some kind of cruel unfair practice perpetrated on the public by the insurance industry. On a superficial level, it does seem perverse that sick people have the most trouble getting health insurance. But imagine if insurance companies did not have that legal privilege. A (highly contrived) conversation with your doctor might go something like this:

DOCTOR: I’m afraid I have bad news. Four of your coronary arteries are fully or partially blocked. I would recommend open-heart surgery as soon as possible.
PATIENT: Is it likely to be successful?
DOCTOR: Yes, we have excellent outcomes.
PATIENT: Is the operation expensive?
DOCTOR: Of course it’s expensive. We’re talking about open-heart surgery.
PATIENT: Then I should probably buy some health insurance first.
DOCTOR: Yes, that would be a very good idea.

So we can see the start of the problem here. Insurance has to be given to groups, not to individuals, because the premiums from healthy people are needed to pay for the medical bills of sick people, and if it were only given to individuals then a disproportionate number of sick people would want to buy it and the system would break down. The American solution to this is generally to group people by their employer. This need to insure people in groups is not just an idiosyncrasy of the American system, but is absolutely essential to health insurance. There is no way to have private health insurance without grouping and more or less compulsory participation within that group. In that sense then, all health insurance schemes are based on people being forced to buy health insurance. The only difference is how you group the people.

Further, people who are insured have to be paying for their insurance in sickness and in health, from early in their lives. No one can be allowed the freedom to wait to buy insurance until they are sick. A system like that just wouldn’t work. As an investment of your own money, you wouldn’t agree to pay for someone’s cancer treatment in exchange for a premium of $500 a month, or even $1,000 a month, possibly not even for $10,000 a month. It is absurd to expect anyone else to do the same. However, you might agree to a contract to pay for someone’s cancer treatment if they get cancer and knowing they do not have cancer now for a modest premium.

So denying coverage for preexisting conditions to people trying to buy insurance on an individual market isn’t just something evil that insurance companies do to make a buck, nor is it just an idiosyncratic feature of the American system. It is an essential systematic feature of any health insurance free market. A health insurance free market could not operate without this feature. It is comparable to denying a homeowner’s insurance policy to someone whose house has already burned down.

(And anyone who tries to wait until they get sick before they buy health insurance is trying to cheat the system—whether that system is public or private—and any system that would allow that is bound to break down, and to reward people for cheating and punish people for playing by the rules.)

So this is the grouping problem. People have to be grouped in order for health insurance to work, and in any health insurance free market some people are going fall outside of any group. Therefore, a health insurance free market denies access to insurance to many people on a mere technicality, based not on whether they are employed or whether they can afford the premium, but on where they work (i.e., on whether or not they can be grouped). Many people who do not qualify for a group plan are just as much productive members of society as those who do. Their exclusion is arbitrary. This is why I would call a health insurance free market a failed market.

The question then is, should attempts be made to correct this failure? The above facts do not answer that question. You are free to decide the answer to that question. But my answer is yes, attempts should be made to correct this failure. I’ll explain below.

Consider how severe the consequences of being excluded from the health insurance market are for an individual. You could incur a crushing lifelong debt, that could prevent you from for example ever being able to own a home when under normal circumstances you would have, and severely curtail your ability to save and invest for your future. You could incur a lifelong disability that could be avoided, or lifelong pain that could be alleviated. Or, you could die.

These are very grave consequences indeed, especially if you are arbitrarily chosen to suffer them on the technicality of where you happen to work.

A logical solution to this then would be to shore up the gaps left in the individual market, and for a government to force insurance companies to treat the individual market the same way they treat a group policy, so that everyone has equal access to health insurance, and coverage is no longer denied for preexisting conditions. But as I said above, we can immediately see a problem with just this one baby step. It sounds very nice, triumph of the little guy over the big evil health insurance companies, leaving all the freedom of whether and when to buy health insurance in our hands. But with a system like this, we’d just be screwing the health insurance companies, and in the process screwing our own selves, as the health insurance companies would just pull out of the market altogether. I know if it was my capital I sure would. You are guaranteed to lose money if the rules of game are that you have to sell a health insurance policy to someone who has just found out they have cancer and is going to be embarking on some very costly treatments. I’d rather invest in Google.

No, a government cannot make it illegal for insurance companies to deny coverage for preexisting conditions without also making it illegal for individuals to not have insurance. The two go hand in hand, and you cannot have the first without the second. You cannot force them to sell policies to anyone without forcing everyone to buy a policy, now, before they get sick. Otherwise people would wait to buy insurance until they needed it, and there would be no way for an insurance company to make a profit by charging any kind of premium people could pay, so no one would invest money in insurance companies and they would all go out of business.

And what we’ve arrived at then is universal coverage. We’re not trying to create a utopia here, not trying to implement a socialist paradise. Not talking about injustice and the poor, and what the government should or ought to do. No, we’ve arrived at a rational reason to want universal coverage by considering simple, basic, and systematic issues of selection biases, by considering the way decisions will be made by individuals and outcomes that will be achieved given certain sets of rules at the outset. We are merely trying eliminate arbitrary exclusion from the health insurance market, because exclusion is so costly.

So universal coverage is not merely another liberal entitlement program as so many of its detractors claim. It is an idea that aims to solve the grouping problem, a simple systemic breakdown in the free market for health insurance.

If you are against universal coverage, then you must find it acceptable for some sick people to not be able to get any insurance at all and therefore be subject to either unbearable debt, bankruptcy, or simply not getting the care they need and possibly dying, due merely to the arbitrary reason that they are unable to become part of a group plan in which their risks and costs are shared by a large number of other people. This outcome results not from any failings of character on their part, and not because they are unwilling to work for a living. It is merely the arbitrary outcome of where they work.

Now, the reality is that in America it doesn’t even work this basically on a libertarian principles. Actually, people without health insurance do often get treated anyway, and the costs get foisted on the public via their bills going unpaid or a program of emergency, government-funded after-diagnosis health insurance. What the individual mandate portion of universal coverage does is force people to participate–pay into–health insurance before they need it, because they or their loved ones will be begging for treatment when they do need it and we as a society don’t really have the stomach to not give it to them just because they either couldn’t get insurance or didn’t think they’d need it before they got sick or hurt. As is pointed out in this New Yorker article, the individual mandate was originally a conservative idea, to make sure everyone pays for what they get. As the conservative foundation that supported individual mandate legislation in 1989 said, “Many states now require…anybody driving a car to have liability insurance. But neither the federal government nor any state requires all households to protect themselves from the potentially catastrophic costs of a serious accident or illness.” Liability insurance is a requirement because the amount of damage a car can do in an accident can easily exceed the amount that an individual would be able to pay. The problems with catastrophic health incidents are very similar.

But I don’t claim to have proven that universal coverage is the only system a rational person would want to live under. There are great downsides to universal coverage. Logically, it probably will stifle innovation. It will probably lead to some rationing and waiting lists. It will probably encourage overuse. If the government were to actually run an insurance scheme, it would be susceptible to bureaucratic inefficiencies that a free market would likely correct with price competition. These are all very real concerns, not to be diminished, and possibly not able to ever be overcome completely. I discuss them in more detail in Part 3.

Ultimately, it is a matter of opinion, not logic, which sets of upsides and downsides you think is better, the ones for health insurance free markets or the ones for universal coverage. The important thing is that you know the full story when you make your decision.

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THAT IS THE foundational point. But there is another point I’d like to make in this first section. The issue of health insurance may be confused in the public debate because, on the surface, health insurance appears to be just like any other kind of insurance. Other kinds of insurance operate just fine on the free market, with no need for government involvement. So why does health insurance need to be treated as a special case?

How Health Insurance Is Different From Other Kinds Of Insurance

Let’s consider one criticism of universal coverage that I often encounter when I state this position, the idea of risk assessment. In selling insurance for anything, whether it’s car insurance or homeowners insurance or health insurance or insuring a concert pianist’s hands, an insurance company assesses the risk that the car will be in an accident, the house will burn down or be flooded, the person will get sick, or the concert pianist will break his or her hands, and on that basis decides whether or not to sell an insurance policy to the person, and if so, how much the premiums will be.

Note that, under a normal insurance market, an insurance company doesn’t have to provide insurance to someone. The insurance contract is entirely voluntary, and its acceptance is contingent on the insurance company being able to make a profit and the insured being willing and able to pay the premium. Either party is able to refuse the contract.

And for most types of insurance, this is a good thing. If someone wants to build a million dollar house right on the sandy part of the beach on the east coast of Florida, it is doubtful that any insurance company would insure them against hurricanes. (Although, insanely, the government probably will.) This therefore discourages people from building a house in such a ridiculous location, even if it is perfectly legal to do so and someone is willing to build it. The insurance company, because it is their money at stake, is doing all the hard work of research and risk assessment and is being the voice of reason. They are not telling you can’t have a home, they  are telling you that if you want insurance you need to build your house elsewhere. And if you are smart you will listen to them.

Or if someone develops a horrible driving record, getting numerous speeding tickets and in many accidents, their premiums will go up and it might even get to the point where no insurance company will insure them at any price and the person may therefore lose the right to drive legally, even before they lose their license. This is also a good thing, as it encourages people to drive safely and responsibly, and removes from the road people who cause most of the problems and dangers there.

But here we can see how a health insurance market is different from any other kind of insurance market. Many reasons a health insurance company would want to deny coverage cannot be simply discouraged. You cannot provide incentives for someone to not get cancer the same way you can provide incentives for them not to build expensive houses right next to the ocean, or to drive safely. You can encourage someone to build a house in a safer area, but you cannot encourage someone to get a less cancer-prone body, or to go get a body without cancer. Unlike houses or driving habits, everyone has a body they are stuck with no matter what incentives are given to them otherwise.

Hang on, not so easy you say. Health insurance is like car insurance. You can encourage someone to drive safer, and you can encourage someone to live healthier. Maybe people who eat horrible food and smoke endless packs of cigarettes deserve to have their health insurance premiums skyrocket or their health insurance cancelled. This is actually a cogent argument. I do believe that people who engage in behaviors that risk their own health should have to pay the costs of those risks themselves, rather than others paying them for them.

The problem with this comparison is twofold: the degree of cause and effect and the degree that someone’s risk profile will rise due to one infraction. Cause and effect is much easier to establish in drivers, where the number of accidents correlates pretty closely with someone’s safe driving habits. In fact, safe driving habits are more or less tacitly defined by their outcomes. If you get in accidents, you aren’t driving safely, and if you don’t, then you are. But behaviors that are judged to be risky to health, such as smoking or eating poorly, have a lower correlation to poor health outcomes, and therefore the insurance company cannot provide as strong of incentives for or against the behaviors. It is also difficult to monitor these behaviors.

(I’d also like to point out that, really, monetary incentives often pale in comparison to the incentive of just not being sick. No one in Britain is getting HIV just because it’s free.)

More importantly though is the degree of risk profile increase. People can get in a single car accident without it ruining their chances of getting car insurance forever. A single car accident, or even a few, raises a person’s risk profile anywhere from moderately to significantly, but they are usually still able to get car insurance, even though it may be very expensive. But a single case of cancer raises someone’s risk profile out of the individual insurance market altogether. And this is completely in spite of how risky their behaviors are. I’ll say it again: it would be like trying get to homeowners insurance after your house has already burned down.

And this goes back to the notion of being stuck in your own body. Anyone who buys a house takes care of all of the insurance issues before they even sign the deed to own the house. To own a house for even ten minutes without insurance would be folly. (And no bank that gave you a mortgage would let you anyway). The same is true of auto insurance, where it is illegal to drive for even ten minutes without liability insurance, and for good reason. But of course, you can’t get health insurance before you get your body. Under a free market for health insurance, there will always be moments when some people are uninsured, even completely upstanding and responsible people, and if they get in an accident or get a diagnosis for an illness during that time, they are screwed.

So those are some of the ways in which health insurance is different from other types of insurance.

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ONE OTHER THING that needs to be covered as groundwork for understanding health care is that discussion of ‘price’ versus ‘cost’ I mentioned earlier. This is possibly the most frequent and pernicious error made in the public discussion of health insurance.

The Difference Between Price And Cost

Economist Thomas Sowell provided my first exposure to this idea, in an article in Capitalism Magazine (which can also be found in his excellent collection Ever Wonder Why? And Other Controversial Essays):

If you ask most people about the cost of medical care, they may tell you how much they have to pay per visit to their doctor’s office or the monthly bill for their prescription drugs. But these are not the costs of medical care. These are the prices paid.

The difference between prices and costs is not just a fine distinction made by economists. Prices are what pay for costs—and if they do not pay enough to cover the costs, then centuries of history in countries around the world show that the supply is going to decline in quantity or quality, or both. In the case of medical care, the supply is a matter of life and death.

The average medical student graduates with a debt of more than $100,000. The cost per doctor of running an office is more than $100 an hour. The average cost of developing a new pharmaceutical drug is $800 million. These are among the costs of medical care.

When politicians talk about “bringing down the cost of medical care,” they are not talking about reducing any of these costs by one cent. They are talking about forcing prices down through one scheme or another.

The cost of health care is how many resources are actually required to provide it, including drugs and implements, doctor’s fees and nurse’s salaries, administrative costs, the costs for the buildings, the costs for developing new drugs, implements and procedures, and the costs for malpractice suits and insurance. When the government promises to bring down the cost of health care for poorer people, they really mean they promise to bring down the price. And if the government mandates lower prices for some while the costs remain the same, then that means the price must be raised for others, i.e., the portion of the cost that those given the lower price don’t pay must be paid by someone else.

And it is ultimately always individuals who pay. If the government pays that portion, then it is actually individual taxpayers who pay it. If the government mandates that insurance companies pay it, then it is actually other policyholders with that insurance company that pay it. The buck always stops at individual people; there is no way to foist the cost off on an organization or institution and avoid having individuals pay it.

This is important because right now the cost of health care is higher in the U.S. than anywhere else in the world (as far as I know). And Americans also pay the highest prices for visits to the doctor (as far as I know). Right now politicians are promising to reduce the price of health care for some people. But no matter whether they use the word ‘cost’ or ‘price’ or make a promise such as ‘affordable’ health care for all, they are mostly only addressing the the price issue, not the cost.

Nevertheless, they would surely like you to think they are addressing the cost issue as well. It is important that you see through this. Likely, they are also trying to implement measures to bring down the costs, but if we let them fool us into thinking that bringing down the price for some people is bringing down the cost, then we will give them credit for something they haven’t done and may end up ignoring important issues regarding why health care costs are disproportionately high in the United States compared to other countries (I cover one aspect of this in Part 3 section 3b). It’s important that you know what your elected leaders and representatives are and are not actually accomplishing, so that you can hold them accountable as you see fit, according to your values. It’s important to see that providing affordable health care for poorer people is mostly an entirely different issue than figuring out how to bring down the cost of health care.

It’s also interesting to note that you can be for either one without the other. You can be interested in bringing down the price of health care for poor people without having any interest in bringing down the cost. You can also be interested in bringing down costs without wanting to provide lower priced health care for the poor.

It’s not only important to understand the difference so as to keep our elected officials honest. Confusing the two issues can cause problems when comparing the American system to another system, as people often do in this debate. If someone goes to a doctor with a cold in Japan, where I live, and they are not part of the national health scheme here but instead choose to pay cash, they can see a doctor for about $30. To do the same without insurance in America might cost $100. Presumably these prices reflect the underlying cost of those doctor visits, and it is valid to compare the two situations. But if someone in America goes to the doctor with health insurance, they may pay a $20 co-pay, while their insurance pays the rest. But this doesn’t make it cheaper to go to the doctor in America than Japan. Similarly, if an American is griping about health care costs in America, it doesn’t make much sense for a British person to say that health care is free in the UK. They are each talking about completely separate things, but making the mistake of using the same word for it. It’s not free in the UK; they pay a premium through their taxes, and don’t pay any price for individual visits and procedures. But the costs are still there. They are less than the costs in the U.S., but they are still there.

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Final Comments On The Basic Problems With Health Care In The Modern World

It seems to that the main problem with health care in the modern world is that many people are simply in denial as to how much the care we want really costs. No one wants to pay the prices to cover the real cost. Many conservatives want to keep the cost of insurance artificially low by retaining the right to deny medical services to a portion of the sick and injured population, those who find themselves not a member of an insurable group. Many liberals want something that is impossible: when you examine it closely, beyond the feel-good rhetoric, what they are asking for is that the government pay for health care so they the people don’t have to. This is utterly absurd. The money the government would use to pay for this health care is their money, the people’s money. Whether it goes through an insurance company, the government, or straight from their pocket to the doctor doesn’t change the face that it is their money. And people in countries that already have universal coverage simultaneously complain about the high premiums they must pay to the system and the poor quality of the service. There are of course many ways to increase the efficiency of any system and thereby cut costs, but at bottom, if we would just admit to ourselves that a lifetime of the modern medical care each of us desires, from cradle to grave, is necessarily going to be a large portion of our lifetime earnings (say, for the sake of argument, 30-50% of an average middle-class lifetime income), then much of our hand-wringing would go away. If everyone of similar income was paying a similar amount for it, and therefore had a similar amount of disposable income each month, all other things being equal, then few people would feel the pain of the cost.

Then again, there may be a permanent and intractable supply problem. Maybe there just aren’t enough people in the world who want to be doctors, or who have the native ability to be doctors, to meet our demand for medical care. Already most first world countries have to take doctors away from the third world to meet their needs, and the third world is left under-treated. We could raise what we pay doctors as an incentive, if we’re willing to admit to the actual cost of medical care and pay doctors what they are worth, but at some point increased pay is going to give us diminishing returns, both in the number of people we attract to the field and in the quality of the doctors we create. So possibly our reality check will be two-fold: admitting to the actual costs of the care we want, and to the limits on the care we can get.

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Parts 2 and 3 are both offered for anyone who wants to engage in the issues further and likes the way I’ve dealt with it so far, but the most basic and essential information has already been provided here in this first part. Parts 2 and 3 can be read in any order.

Health Insurance Part 2: Other Reasons To Favor Universal Coverage (Applications Of The Logic Supplied In Part 1)

Health Insurance Part 3: How Universal Coverage Fails, And Possible Ways To Mitigate The Failure.

I don’t know if quoting such long portions from Wheelan and Sowell is  copyrightorilly acceptable, but perhaps I can offset that by recommending the works from which I quoted as being of the same excellence throughout as the portions I quoted here. Wheelan’s Naked Economics is chock full of surprising and fascinating economics lessons on par with the one quoted here (just get a load of his analysis of the airline industry), all of which even the most casual reader can understand. A lot of what Sowell writes is also great, but while Wheelan is a centrist, Sowell is an arch conservative, and I have more complicated feelings about him. You can read more about those in my post What Every Liberal Should Know: Thomas Sowell’s Basic Economics.

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3 CommentsLeave a comment

  1. Hi! I would also appreciate if you could opine on the Obamacare insurance machination.
    Thanks!

  2. Hi! you have elucidated the health insurance failure milieu quite intelligibly. But I have one apprehension, as I understand that USA’s PPP is higher as compared to that of UK’s, thus the buying of the medical services in USA should incur lower cost than that in UK (in there case what they pay as taxes for the medical service) but you have expressed just the contrary. isn’t that a discrepancy?

  3. Thumbs Up!!


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