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Three Cheers For Individual Health Insurance



March 15th, 2010

The most significant and most radical change to the health care system that President Obama is proposing is to virtually eliminate the market for individual insurance and replace it with a highly-regulated health insurance exchange. But why would anyone want to do that?

One reason is the persistent myth that the market for individual insurance is broken. An extreme version of the myth is contained in an article in Health Affairs during the 2008 election by Sherry Glied and others, attacking John McCain’s proposal to replace all the subsidies for health insurance with a lump sum refundable tax credit of about $5,700 for every nonelderly family. You would think this proposal would be an enormous boon to the currently uninsured. But Glied’s complaint was that some 20 million people would leave the small group market for the individual market — where some of them would be discriminated against because of pre-existing health conditions. Note: She was not arguing that McCain’s idea was worse than ObamaCare. She was arguing that McCain’s idea was worse than doing nothing at all!

A new book by Mark Pauly, however, puts all such nonsense to rest. Turns out, the market for individual and family policies works reasonably well — certainly better than the small group market. And with a few reasonable reforms, it would work better still.

Let’s briefly review the positive side of individual insurance:

Choice of benefit packages. Whereas in most small and even medium-sized businesses, employees have little, if any, choice of health insurance coverage, in the individual market people typically have a great deal of choice. This is important. If you want to persuade people to voluntarily insure, you’ve got a much better chance if you give them what they want.

Guaranteed renewability. Despite some well-publicized cases that have become fodder for the political debate, individual insurance has historically been guaranteed renewable in the same rate class. This means the insurer cannot single you out either for cancellation or a rate increase because you happened to get sick. Moreover, under federal law, this has been a nationwide requirement ever since the passage of HIPAA. So, contrary to some misinformed rhetoric, people in the individual market are always in large pools and the rate increases are the same for everybody in the pool.

The same is not true of group insurance, however. A small group is a self-contained group; and in most states insurers can increase rates (sometimes a lot) just because one employee had an expensive health problem. Moreover, group insurance is never guaranteed renewable for the employee. Once you leave your job, you ultimately leave your health plan as well.

Portability. Individually-owned insurance travels with you on your journey through the labor market — both from job to job and when you leave and reenter the market. Except in a few isolated industries, group insurance is never portable.

More accurate entry prices. Because of health underwriting, premiums charged to new entrants tend to reflect expected health care costs. In most discussions this is treated as a disadvantage. And for the 1% to 4% of people with an expensive-to-treat, pre-existing condition, it is bad. (More on that below.) But to the other 96% of the population, more accurate pricing is a good thing. And it’s not just personally good for them. It’s also socially good. Inaccurate pricing creates perverse incentives. Those who are overcharged will underinsure, and perhaps not insure at all. Those who are undercharged will overinsure.

Community rating (and guaranteed issue), Pauly argues, is comparable to imposing an excise tax on the vast majority who are healthy in order to subsidize the few who are less healthy. No matter how desirable the goal, the method is wrong. Economic theory teaches that broad-based taxes are always superior to excise taxes; and in health care this lesson is particularly important because there are adverse social consequences of the decision of healthy people to stay uninsured. (Wherever community rating is imposed, it always seems to increase the number of uninsured.)

Reviewing The Alleged Downsides Of Individual Insurance

Okay, so what’s the downside of individual insurance? The complaints most often heard are that people with pre-existing conditions may face exclusions, waiting periods and even denial of coverage altogether. While Pauly acknowledges that individual families may find themselves in tragic circumstances (the kind President Obama has encouraged everyone to write to the White House about so they could be publicized), the dimensions of the problem are actually quite small.

For example, Pauly finds that “exclusions affect very few people and often have modest effects when they do.” Also, “in unregulated markets, waiting periods are rare and brief (if coverage is delayed, it is usually for only a month or so), but exclusions are common, though usually limited to two years or less.” As for denial of coverage, this is also overblown. According to one study, “Almost every potential buyer, even with a chronic condition, was eventually able to get an insurance offer if [he/she] persisted in searching among companies despite being rejected at the first application.”

What about the oft-heard complaint that high-cost patients get trapped in pools with escalating premiums? Turns out that “only about 15% of the higher cost of a chronic condition actually shows up in the higher premiums paid by people with such conditions in the individual market.” Individual insurance is not only portable across jobs; it appears to also be portable across health conditions as well.

Moreover, what problems there are in the individual market are more often than not exported from the group market because of the lack of portability there. It is probably fair to say that the defects of the group market get shifted to the individual market far more often than the other way around.

Another complaint is the high administrative costs in the individual market, where only 65% to 75% of premiums are actually paid out in claims. By contrast, the comparable figure would be 95% for very large groups (10,000 employees or more).

One reason for high administrative costs is selling expenses — persuading people to buy. But where insurance is highly subsidized, selling expenses go down. With employer-provided insurance, for example, where the typical employee pays only 25% of costs, the takeup rate is about 90%. Pauly even raises the possibility that generous subsidies could pay for themselves (in terms of overall social cost) — which means that the fall in selling costs could more than offset the expense of the subsidy.

So what can be done to make the individual market work better? The most common proposals are disappointing:

  • Online buying (touted by some on the political right) has lowered administrative costs and increased competition for some kinds of insurance, but for health insurance the gains appear very modest. (Underwriting and the exchange of information appear to be done largely offline on a personal basis.)
  • Another idea often pushed by Republicans is voluntary buying associations; but these never last because healthier members eventually find they can do better by leaving the group.
  • Health insurance exchanges (favored by the Obama Administration) usually come with price controls and regulations that undermine any potential benefits. Also, there is no evidence that administrative savings in Massachusetts are any lower than would have been produced by the subsidies alone.

Pauly has three suggestions that will have positive impact. First, individual insurance should be subsidized through the tax system. At a minimum, people buying their own insurance should get the same tax break employees get. A better approach is a fixed sum tax credit, along the lines suggested by Pauly and me some years ago in Health Affairs. Second, we need better functioning risk pools, and the need for such pools would be lessened if more insurance were guaranteed renewable (as it would be, for example, if employers could buy individually-owned insurance for their employees).

Finally, health insurance would be more attractive if people had more choices. One way to achieve that is to repeal mandated benefit laws, requiring insurers to cover providers, ranging from chiropractors to naturopaths, and services, ranging from in vitro fertilization to acupuncture. Alternatively (and although Pauly doesn’t advocate it), we could give people a choice of regulatory regimes by allowing them to buy insurance licensed in any of the 50 states.

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1 Trackback for “Three Cheers For Individual Health Insurance”

  1. uberVU - social comments
    March 15th, 2010 at 7:00 pm

3 Responses to “Three Cheers For Individual Health Insurance”

  1. John Ballard Says:

    Insurance is a challenge, but the underlying problem is health care inflation. If that were not out of control we would not be having this conversation. It matters not whether medical bills are paid by companies, employees, tax subsidies or some elegant combination of them all. Unless and until health care costs are curbed no amount of prestidigitation will make insurance more affordable for taxpayers or individuals.

  2. Brian R Williams Says:

    Great post.

    Moving the direction John Goodman describes would create a competitive, affordable market that provides real insurance against the risk of illness, instead of the current expensive pre-paid health care system that we have now.

  3. Devon Herrick Says:

    Regulations requiring insurers to charge everyone the same premiums (community rating) and decline no one due to pre-existing conditions (guaranteed issue) are destabilizing to health insurance risk pools. Premiums in Massachusetts, New York and New Jersey are prime examples of what happens when those with few medical needs are asked to pay more than their expected costs so older, less healthy individuals get a bargain. Moreover, it doesn’t even work in the employer market. According to Kaiser Family Foundation’s latest survey, the average cost of a health plan through an employer was $13,375 in 2009 (nearly $5,000 for an individual worker). The only reason workers tolerate the high cost of employee health benefits is because they do not realize they are the ones paying for them.

    There is also a moral hazard problem when premiums cannot be used to discourage unhealthy behaviors that drive up the cost of risk pools. Everyone agrees that we need more prevention and healthy lifestyles. Individual plans (with guaranteed renewability) that can adjust rates for healthy behaviors will rein in spending much better than community-rated plans.

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