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Health Reform without Side Effects: Making Markets Work for Individual Health Insurance

Health Reform without Side Effects: Making Markets Work for Individual Health Insurance

by Mark V. Pauly

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Mark V. Pauly offers a detailed look at the individual insurance market in the United States. He explains how it works, suggests approaches to improvement that build on what currently works well, and provides a realistic assessment of how much improvement we can demand and expect. He concludes that, although there are some serious deficiencies in today's individual


Mark V. Pauly offers a detailed look at the individual insurance market in the United States. He explains how it works, suggests approaches to improvement that build on what currently works well, and provides a realistic assessment of how much improvement we can demand and expect. He concludes that, although there are some serious deficiencies in today's individual insurance market, there are also some important advantages in this market that should be preserved.

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Health Reform Without Side Effects

Making Markets Work for Individual Health Insurance

By Mark V. Pauly

Hoover Institution Press

Copyright © 2010 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
ISBN: 978-0-8179-1046-4


Problem definition

Medical care is expensive because it is a prodigious consumer of high-value real resources, principally labor but also some capital and technology. In the long run, it can be made a little cheaper if consumers are willing to sacrifice some current features of care, but it cannot be made low cost. Its price can be temporarily lowered because some labor inputs (principally health professionals) have few equally attractive short-run alternatives: doctors' net incomes and nurses' wages can be squeezed for a while, although this only redistributes welfare and does not lower real resource cost and must be temporary. Health insurance premiums are high, and growing, because the medical costs they cover are high and growing. Health insurance and health care just cannot be made permanently "affordable" to low-income households except through subsidies. Someone has to pay for others, and someone has to decide how much to pay and for what.

However, medical care also provides high and growing benefits for our lives and those of our loved ones, and, on average and up to this time, the benefits appear to exceed the cost. So the nonpoor bulk of the population will still want care and would want it even if they have to pay the full high cost. To evaluate how well alternative ways of financing perform, we need therefore to begin by estimating how much care a household should have based on its own resources and then adding to that the contributions other citizens are willing to make if the household's own efforts fall short and it is thought to be in need.

How much care should a person have, and how should it best be paid for? We focus primarily on the nonpoor, because most of the population is not poor, but we deal as well with attempts to help the private individual market to work for low-income families. We begin with the premise that consumers should be well informed and that they should at least get the care they want and are willing to pay for on their own behalf. The pedantic economic planning model gives the same answer to this question as for all goods and services: the person should get care up to the point at which its additional benefit to that person equals its real resource cost given the person's health state and income. The person and the person's household should then pay for that care in a way that protects household wealth from the threat of high spending because of the uncertain occurrence of serious illness that is expensive to treat; there should be insurance.

These concepts of the ideal are abstract at this point, but they are more useful and more meaningful than some other suggested alternatives. People talk about the right to medical care, but they do not say how much is rightful or how it should be produced and paid for. Or they talk about "the right care of the right quality at the right time and at the right price" but do not tell us what "right" means. It surely does not mean what doctors would most prefer, or even what insured patients would most prefer (given in both cases that insurance is paying). Determining the benefit of more care to a given person requires knowing what the doctor knows (how sick the person is and what care provides what benefit), but this information must be combined with what the consumer-patient knows about the value placed on health outcomes relative to other uses of income and on side effects and costs (monetary and nonmonetary) of treatment.

Traditional health insurance usually gets in the way of making a good joint decision because it makes expensive services appear artificially cheap. There needs to be a trade-off between this inappropriate stimulus to high use and high cost (called "moral hazard" in the insuranceliterature), on the one hand, and financial risk protection on the other (Pauly 1968). With sufficient information, consumers of insurance can make all of these trade- offs, but getting the information can be challenging and costly. Still, it seems plausible that the bulk of people who are middle class and above choose enough coverage and enough care that others would not have great concern for (and be willing to pay much more for) their additional use of care or additional insurance benefits. If anything, among the middle class there is more overuse (benefit less than cost) than underuse (the reverse), and a solution to the problem of underuse for them is better and more persuasive information for those unaware of the benefits from care, not more insurance for all. As will be argued in more detail below, markets for care and markets for insurance for the nonpoor have no serious intrinsic impediments to good functioning, but they do require care and feeding and are easy to mess up.

For lower-income households in America (given moderate risk levels) and for high-risk households (given moderate income), this reasonable state of affairs does not apply. Generous subsidies for better care are needed for them. Fortunately, subsidized insurance can both provide financial protection and reverse moral hazard for community benefit, stimulating the use of care that others value more than the person can or does.

The majority of uninsured Americans are not poor, obtain their income from employment (including self-employment), but do not work in firms that offer them employment-based group insurance coverage. While reform could try to put many of these people into Medicaid or other public plan or (through an employer mandate) into employment-based insurance coverage, such changes would be large, awkward, and difficult. A more natural setting for covering the bulk of the uninsured is the setting already used by about 30% of people like them — the individual insurance market (Pauly, Percy, and Herring 1999). But this market is generally regarded (correctly, as we shall see, in its current form) as a relatively poor performer, both in terms of efficiency of administration and in terms of the efficiency-equity issues surrounding risk variation. In individual insurance, to put it bluntly, you pay a lot for what you get, and, if you are unfortunate enough to become a high risk, you pay even more or get even less. However, this bad reputation masks some real advantages to this market, even as it is, and, more importantly, inappropriately excludes this market from consideration for modifications that could reduce the bad features and enhance the good ones.


The lay of the land: How many people have what problems?

Not all parts of the private U.S. insurance market are yet in disarray. The market works well — at least as well as is possible, given the cost of health care — for very many people, but very poorly for others. We will use two measures of "works well." One is whether people end up obtaining insurance. The other is what they have to sacrifice to get insurance. The first indicator is measured by the proportion of those not receiving public coverage who have private coverage. The measure of the second indicator is more complex, since the alternative to paying nothing for health insurance is not usually getting good medical care for free; rather, it is being at risk for high out-of-pocket payments for constrained care of questionable quality or going without. The real cost of protecting yourself against the risk of uncertain medical spending is the difference between what you pay or would pay for health insurance and what you expect on average to get back as benefits. For a set of similar risks buying the same policy, this cost is the difference between total premiums paid and total benefits received; in insurance parlance this is called the "administrative loading" (or just "loading") on insurance. This measure of insurance price or cost is not perfect since it does not capture the offsetting benefit of getting more care than if one were uninsured, the offsetting cost of that care, and the nonmonetary cost of being limited in what care you can get and from whom by a managed care insurance plan. But it will do for a start. Economic theory and definitive empirical research tell us that the higher the loading, the less attractive is insurance, other things equal, and the more likely people are to choose to be uninsured or not make strong efforts to become and stay insured. The punchline: the worst off a person or group can be is when they are often uninsured and would pay a high loading for insurance if they got it.

There are two primary determinants of who gets and keeps health insurance in the United States: decent income and employment at a large firm. The role of income is shown in Table 1. As indicated there, the likelihood of being uninsured for a person under 65 is only half as high if the person is in a household whose income is at or above 400% of the poverty line than if the person is poor or near poor, even with Medicaid as a public safety-net program for the poor.

Even so, uninsurance is not unknown among the middle class (the median U.S. household income is at about 325% of the poverty line), and a quarter of the uninsured (11.6 million out of 45 million) are above the 300% cutoff. (See also Yegian et al. 2000.) The table also shows that, at about 160% of poverty and above, most people somehow get private coverage. The implication is that, while income matters, there is more to coverage than just income or affordability.

Table 2 indicates the second major influence: firm size. The measure of size in this data is not ideal. We must look at "establishments" or places of employment, rather than firm size, because a large employer such as a fast-food chain may be composed of many small establishments. But since a large establishment cannot be part of a small firm, the measure still serves to indicate the effect of firm size, and the message is clear: even for workers in relatively low-income households, insurance is common if they work for a large employer, while well-off workers at small firms may be uninsured.

I will discuss what are the "active ingredients" that make insurance markets work well for large firms in more detail below, but for the present it is sufficient to note their relatively good performance in terms of both coverage and administrative cost. The few uninsured people who work full time in large firms are usually not eligible for coverage, often because they have just begun a job or are in a near-minimum-wage job, or, much more rarely, turned down offered coverage because they are not willing to pay the explicit employee premium. About 4% of the under-65 population offered employment-based insurance will not take insurance if they have to pay anything for it, no matter what. (For two-worker families, one worker will often enroll as a dependent on the spouse's plan.) The table further subdivides households with a large-firm worker by household income; there is a modest effect of income on the proportion with coverage but the proportion is above the national average regardless of household income.

There are two other employment-related categories: those who are employees at small firms and those who are not employees of any firm, either because they are self-employed or not working. Here the picture is quite different. In these categories, the number of uninsured is high, even among relatively high-income households. It is highest of all among people who do not at present have a group insurance option (although in principle anyone could try to get a job at a large firm); it is also high for middle-class people who work at small firms.


Can individual insurance help?

Those in households where no group insurance is offered (whether or not the person works as an employee) are "at risk" for purchasing individual insurance. Performance of this form of insurance is not impressive; in this case, insurance reaches only about 25% of the population. But many of those who work as employees could have taken jobs at firms offering coverage. A sub-population with no alternative but individual insurance would be those who are self-employed or not employed; here the proportion with coverage is still low, at about a third (Marquis et al. 2006).

The proportion of the population with private insurance has been trending downward, to some extent offset (and perhaps caused) by expansion of public coverage, especially through Medicaid and the State Children's Health Insurance Program (SCHIP). The fall in privatecoverage has not generally occurred among people in households with a worker at a large firm, in part because such firms continue to offer coverage and in part because household incomes for workers at large firms are higher and therefore less subject to crowd-out from public plans. Moreover, although the data is somewhat soft, it appears that the erosion in coverage for workers at small firms does not largely result from firms dropping existing coverage, but rather from firms that do not offer coverage replacing firms that did. There has also been some tightening of eligibility so that more workers in firms that offer coverage do not qualify.

Table 3 provides some rough data on the components of administrative cost for insurance bought as group coverage or as individual coverage. The loading is higher the smaller the group, and it is also more variable. This pattern and its rationale will be discussed in more detail below, but the main message is clear: the administrative loading, and therefore the true price of insurance, is much higher for individual than large-group insurance. This table differs from the original calculations (created by the Hay Group in 1999) in reducing the estimated charge for claims processing to a more uniform percentage; it also makes an estimate for individual coverage based on extrapolating the very small group numbers and using other evidence in the informal literature.

The time trend in the loading percentage has been modestly upward across the board; the average loading in private insurance has probably increased by 1 to 1.5% of premiums over the last 20 years. This is largely due to the spread of managed care, which is somewhat more costly to administer (per dollar of benefits or premium) than was old-style insurance, which just paid claims but did not select panels of providers, preapprove coverage, or attempt to manage care. This growth in cost seems to be fairly uniform by group size on average, although anecdotes of substantial increases in premiums are much more common in the small-group and individual markets; there is more dispersion in premiums in such markets.

The extent of competition among private insurers measured by firm market shares (in states or cities) has never been very high. In most areas, the Blue Cross and Blue Shield plans have dominated for many decades, often with market shares in the 80–90% range. The share of the largest non-Blue for-profit plan has never been greater than 25%. There have been some exceptions and some changes to these generalizations. In California and New York the Blue plans were never as dominant, and both private for-profit insurers and independent managed care plans were important. There has been consolidation and change during the past decade; the independent HMOs were bought up or disappeared, some of the Blue plans converted to being investor owned, and the separate Blue plans with different geographic territories merged. Data are soft here as well because some consumers have policies from more than one firm and because self-insured employers really do not buy insurance from any insurance firm, even if they use an insurance company to process claims or organize panels to supply medical services.

The Blues still dominate, with about 100 million out of about 170 million total privately insured. Accounting for the Blue plans that are non-investor-owned, the market splits about 50–50 between for-profit and nonprofit or mutual (consumer cooperative) firms. Historically, the Blue plans were typically even more important than other insurers in the individual market, although United Health Care now has a substantial individual presence due to its acquisition of Golden Rule Insurance, and the investor-owned (but Blue) Wellpoint firm is active in the individual market as well (though individual insureds are only about 7% of the total population for which it administers insurance). Only concentration, not ownership form, appears to affect competition, and there is some evidence that high concentration in managed care does lead to monopoly behavior in the HMO market (though not necessarily in the overall health insurance market) (Pauly et al. 2002). Profit levels do not yet signal generally high market power, even when the number of insurers selling in a market is small; net income of private insurers was negative or very low in the later 1990s, and has recovered, but profits as a proportion of premiums rarely exceed 5%. The local markets in which one insurer is dominant are always dominated by a Blue firm, which is usually nonprofit and subject to greater state scrutiny than commercial insurers.


Excerpted from Health Reform Without Side Effects by Mark V. Pauly. Copyright © 2010 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Meet the Author

Mark V. Pauly is the Bendheim Professor in the Department of Health Care Systems at the Wharton School of the University of Pennsylvania.

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