In part one of this series, we looked at the underlying reasons why healthcare is so expensive. We now focus on health insurance and the role it plays in causing our health care system to be more dysfunctional than it need be. We’ll see that the health insurance system which has evolved here in the United States both contributes to the high cost of medical care and creates additional impediments to providing health care to the population as a whole.
An Historical Perspective
In order to understand health insurance in the United States, it’s necessary to know a little about how the system evolved into what we have today. An excellent history can be found here and I encourage you to read it.
To summarize, the modern health insurance system has its roots in the 1920’s. Around this time, costs for medical care began to rise due to advances in technology and a subsequent increase in demand. In addition, increased requirements for physician licensure, education and the accreditation of medical schools restricted physician supply, putting upward pressure on the costs of physicians’ services. As the demand for hospital care increased in the 1920s, a group of Dallas teachers contracted with Baylor University Hospital to provide 21 days of hospitalization for a fixed pre-paid amount. Ostensibly, the plan developed as a way to ensure that people paid their bills, and over the course of the Great Depression other pre-paid hospital service plans sprung up. These plans were mutually advantageous to both subscribers and hospitals at a time when both groups suffered from falling incomes. While the pre-paid plans allowed consumers to affordably pay for hospital care, they also benefited hospitals by providing them with a way to earn income during a time of falling hospital revenue. The plans eventually combined under the name Blue Cross. This consolidation was encouraged and facilitated by the American Hospital Association in order to limit competition among the plans. Physicians subsequently created a similar pre-paid plan for their services which became known as Blue Shield. The success of the Blues persuaded commercial insurers, who initially considered medicine an unpromising market, to enter the field.
During World War II, the government instituted wage controls which made it difficult for employers to compete for a limited labor supply. To get around this government intervention, employers began to offer health insurance as a way to attract prospective workers. After the war, the government further encouraged this practice by making these employee benefits tax exempt for both employer and employee. In response, private insurers accelerated their efforts to sell policies to groups of employees through employer sponsored plans.
How Insurance is Suppose to Work
As a result, we now have a health insurance system which is not actually insurance in the traditional sense. Normally, we purchase insurance to protect ourselves against the risk that we will experience some unexpected loss event. We don’t anticipate that the event will actually occur and we hope that it doesn’t, but we buy insurance just in case it does and we suffer a huge loss. A good example of this is homeowners’ insurance which protects us against catastrophic losses such as fires, floods, burglary, etc. Insurance companies provide this kind of insurance by spreading the risk of loss among a large pool of insured customers. In this way, they protect us against a loss that would be substantially greater than we could bear on our own. Everyone pays into the pool, but only an unlucky few ever have to file a claim and be paid. Even in areas where the overall risk is higher than average, such as earthquake zones or places prone to increased fire danger, the risk is still spread out among all customers while only a fraction actually incur a loss. Though customers who are at a higher risk for payout, either due to factors that make them more prone to a loss or because their replacement costs are higher than average, are necessarily charged a higher premium, the insurance model to protect us against catastrophic losses generally works well.
In contrast, we don’t purchase insurance for routine home maintenance or minor losses because these are events that we should be able to anticipate and can pay for on our own. Buying such insurance would make little economic sense because everyone in the risk pool would be filing claims on a regular basis. A part of the premiums paid into the risk pool would quickly be consumed by administrative costs and profits for the insurer and less would be available to pay for claims. We’d pay more in and get less out. As explained in part one of this series, another factor that makes purchasing insurance for minor expenses inefficient is the effect of moral hazard. If insurance companies insulated us from the direct cost of home maintenance, the costs for those services would quickly rise. Homeowners would purchase more services to “get their money’s worth” while at the same time having less incentive to shop around for the best price. Premiums would spiral upwards and those who could not afford to purchase a plan would find that they also could not afford the increased costs to repair their homes and property values would drop substantially. Overall, it would be a disaster. Clearly, the insurance model should be used only in cases where the potential loss would be significantly greater than we could bear on our own. In all other cases we are much better off paying for non-catastrophic expenses directly, rather than using insurance as a pre-payment plan to insulate us from these costs.
Today’s System is Not Really Insurance
Now compare this to what we call health insurance. Unlike homeowners’ insurance, health “insurance” covers routine medical care as well as catastrophic medical expenses. In addition, most Americans don’t actually purchase their own insurance; they receive it as an employment benefit, often in lieu of additional salary. As a result, they wish to get the most out of this benefit as possible. Rather than hoping they never have a claim, they feel that if they don’t use their insurance, they have lost out on something owed to them. Regardless of whether it is purchased directly or provided as an employee benefit, health insurance is viewed, not as a hedge against risk, but rather as prepayment for future services. So while a relatively small percentage of homeowners’ insurance customers ever require payment on a claim, virtually all health insurance customers receive some reimbursement for routine care, and the few who become very sick require very large payouts. It should be clear now why this mix of pre-paid medical care and insurance against catastrophic expenses makes it almost impossible to offer medical insurance for a reasonable price, especially at a time when the cost of medical care is rising due to the reasons discussed in part one.
How Health Insurance Companies Contain Costs
Insurers, in response to these economic realities, employ various means to reduce their expenses. In the early years of the industry, insurers primarily kept costs in line by negotiating a reduced rate from the doctors and hospitals who agreed to accept their “insurance”. In return, medical providers had access to a larger pool of patients who had an increased demand for their services since they were partially insulated from the direct cost. Furthermore, at that time, medicine offered fewer options for routine care or for those that became seriously ill, so even when claims were made, the payout was not exorbitant.
With the explosion of premium medicine and an aging population leading to higher and higher medical bills, insurers began to explore additional ways to lower costs. Insurance premiums, co-payment amounts, and deductibles all were increased, while remuneration to healthcare providers for various services decreased (resulting in cost shifting to the non-insured). In addition, insurers instituted lifetime caps on benefits and began to routinely deny claims for “unapproved” services or those they deemed “experimental”.
Another important way insurers seek to limit their claims liability is to deny coverage to applicants who have pre-existing conditions or are at greater risk for medical problems. Contrary to popular belief, this is not some nefarious scheme to prevent those that truly need insurance from obtaining it. Insurers have always been concerned with the phenomenon called “adverse selection”. This is the tendency for older or less healthy people (those who have pre-existing conditions or anticipate large medical bills) to be more likely to purchase health insurance, while younger, healthier people (who see medical insurance as an unnecessary expense) avoid purchasing it. As a result, the insurance pool becomes more heavily comprised of people who pose a large financial burden on the benefit pool. This causes an increase in premiums, which in turn drives away the more desirable younger, healthier clients, who see even less value in an expensive product they are unlikely to use. The risk pool is then further skewed towards more expensive clients, further driving up costs. From an economic standpoint then, it makes perfect sense for insurers to seek out healthier clients and avoid those with pre-existing conditions.
This problem is further complicated when applicants either willfully or inadvertently fail to disclose these pre-existing conditions on their applications. The insurance industry’s response has been to retroactively cancel policies when these oversights become known. Unfortunately, it is often difficult to determine whether an applicant has intentionally hidden or unknowingly omitted their pre-existing conditions and the insurance industry often makes no attempt to distinguish between the two groups. In fact, some insurance companies have gone so far as to cancel policies when they discover unimportant and minor mistakes on a customer’s application. Clearly, there is no reasonable justification for such actions and the resulting hardship imposed on patients that have been caught up in these actions is unconscionable.
How Government Intervention Has Made Things Worse
Individuals Are Tied To Their Employers
Previously, we discussed how government tax and wage policies encouraged the explosive rise in employer sponsored health insurance plans. (Union demands for more benefits also played a part, but that discussion is beyond the scope of this article.) This has lead to the vast majority of insured Americans being covered under one of these plans. While government intentions may have been laudable, the result has been that those covered under employer health plans are tied to their employers if they wish to continue to be insured. If they want to change jobs or relocate, they must find an employer that offers health insurance benefits, especially if they have any health problems that might cause insurers to exclude them from individual coverage due to pre-existing conditions and then wait some period of time (usually 12 months) for those conditions to be covered. The problem is much worse for those who lose their jobs and become unemployed. Even if they could afford a more expensive individual plan, they are often denied coverage because of a pre-existing condition, a situation which is more likely if they are middle aged or older. For those who are unlucky enough to become unemployed due to illness, their circumstances often becomes dire. First, their income is reduced or eliminated. Second, they lose their health insurance because they are no longer eligible to be covered under their employer’s plan. And third, they are uninsurable due to their pre-existing health condition. Add to this their mounting medical bills, and it’s no wonder that medical expenses are cited as a factor in a majority of personal bankruptcies.
None of these problems occur when coverage is purchased through an individual plan because subscribers can retain their health insurance as long as they continue to pay their premiums. It would seem logical then to allow workers to keep the insurance obtained under their employer’s group plan even if they leave their company’s employ. Yet state and federal laws prohibit this practice. True, under COBRA, workers may often hold onto health coverage obtained through a previous employer’s health plan, but only for up to 18 months (36 months in some cases). After that, though, they’re on their own.
Insurance Is Made More Expensive
Health insurance is also heavily regulated by state governments, which almost universally require insurance companies to cover specific diseases, pay for the services of certain types of providers, and/or cover certain types of patients. Other regulations may restrict insurers’ ability to contract selectively with a provider, require insurers to limit premium differences between high risk and low risk individuals, and/or require insurers to sell insurance to all potential customers regardless of health or pre-existing conditions. These laws make insurance more expensive and reduce competition.
If an insurer wishes to sell insurance in a particular market, they must include the types of coverage and benefits mandated by that state’s lawmakers. As these mandates become more burdensome, insurers flee the state, leaving the public with fewer insurers to choose from. Fewer insurers means less competition and less competition means higher prices. In addition, state governments prohibit consumers from purchasing insurance from companies located outside their own state, virtually ensuring that the public will have few options in their choice of insurers. In fact, the average number of insurers per state is 5.6 while some states have as few as two or three health insurance companies vying for customers.
For those companies that do sell insurance in a particular state, the cost of providing that insurance increases with each new mandate. In a 1999 study, Gail Jensen and Michael Morrisey found that “mandates cost money. In Virginia, mandates accounted for 21 percent of health insurance claims; in Maryland, they accounted for 11 to 22 percent of claims; and in Massachusetts, 13 percent of claims”. Likewise, a recent study by the Council for Affordable Health Insurance (CAHI) found that while some mandates increased insurance premiums by less than 1%, others, such as requiring benefits for mental health treatment or in vitro fertilization, increased premiums by as much as 5% to 10%. Considering that states, on average, impose approximately 41 mandates on insurers and some states levy as many as 70, it’s not difficult to imagine the cumulative impact that government regulation has on the cost of health insurance premiums. In fact, the CAHI study estimated that “mandated benefits currently increase the cost of basic health coverage from a little less than 20% to more than 50%, depending on the state and its mandates”. While there’s little evidence that all these regulations and mandates provide much overall benefit (states with numerous mandates don’t have populations that are demonstratively healthier than states with fewer mandates) it’s clear that mandates do contribute to the high cost of insurance and increasing number of Americans without health insurance.
Why So Many Mandates?
The saga of state health insurance mandates is a good lesson as to how things can go wrong when government is given the power to interfere in the free market. The decision as to whether or not to impose a new mandate is rarely, if ever, based on medical necessity. As is often the case, special interests have their way when it comes to making these laws. All health care service providers want their particular service covered under insurance so they can personally benefit. And if they can’t achieve this goal in the free marketplace, they get their legislators to do their bidding for them. Likewise, elected officials find it easy to impose additional mandates in an attempt to court voters that desire enhanced care for their particular needs. As a result, states now mandate that health insurance must cover the services of an ever increasing group of providers including chiropractors, podiatrists, social workers and even massage therapists, as well as benefits for such services as mammograms, well-child care, drug and alcohol abuse treatment, family therapy, acupuncture, and hair prostheses. And the list of mandates continues to grow. In 1989, the Health Insurance Association of America (HIAA) published a study which found that states had passed more than 700 mandates. By 1999 that number had risen to well over 1,000. And for 2009, the CAHI has identified 2,133 mandated benefits and providers. In fact, state and federal mandates are so prevalent that it is virtually impossible anywhere in the country to purchase an inexpensive, bare-bones health insurance policy which covers only catastrophic events. Of course, this is by no means an exhaustive list of the negative consequences brought about by government intervention, but I think you get the picture.
Health Insurance Company Profits and CEO Pay
It should be clear by now that while I’m not a big fan of health insurance companies and the product they sell, I don’t see them as the evil villains they’ve been made out to be. I readily concede that some companies in certain instances have engaged in improper, if not illegal, conduct in retroactively canceling policies or denying coverage without due cause. I would also submit that this is the exception rather than the rule. I would further argue that much of the problems we have regarding insurance coverage in the United States is the result of misguided government policies and not the fault of the insurance industry. I’ve already shown how the huge increase in national health care spending is primarily the result of the rise in “premium medicine” and how government intervention has caused insurance to be more expensive and less available. Yet there are likely readers out there who still believe that many of our health care problems could be solved if the health insurance industry took fewer profits and reduced the pay of their CEOs.
Typical of this type of thinking is the following comment found on a blog post which listed health insurance company CEO total compensation in 2008. From the Health Reform Watch website:
CEO compensation in the health care insurance industry is outrageous. Can anyone explain to me, or to the public at large, how such large compensation packages improve health care access for the ordinary citizen. How may people could get insurance if the CEO’s would limit their compensation to 40 times the lowest paid employer in their companies?
First of all, this is kind of a silly argument to begin with. One could also ask, “How may people could get insurance if George Clooney wasn’t paid $20,000,000 for Ocean’s 11?” But let’s do some math and see if we can figure out what might happen if CEOs limited their compensation. The highest paid CEO on the list is, by far, Aetna’s Ronald A. Williams at $24,300,112. (All of a sudden I’m seriously beginning to rethink my choice of careers.) Now, ignoring the fact that much of his compensation likely comes in the form of stock options and that he’s not actually paid this amount of money in a paycheck, let’s see how some of Aetna’s policy holders might have benefited if Mr. Williams decided to work for free and got no compensation at all. According to Aetna’s website, the company has a little over 19 million medical members. There are, of course, other sources of income for the company such as ancillary businesses and subscribers of other insurance products, but let’s say that Mr. Williams’ total compensation was used instead to reduce the premiums paid by these 19 million medical customers. If we divide his compensation by the number of medical members, we find that reducing Mr. Williams’ compensation to zero would net each medical member a whopping $1.26. If I’m not mistaken, that’s about 1/3 the cost of a 12 ounce Starbuck’s latte. As we can see, eliminating the annual compensation of even the highest paid health insurance company CEO would have little impact on policy holders, let alone the millions of Americans who can’t afford health insurance or health care.
Lest you think I’m being biased and ridiculous, let’s see what Factcheck.org has to say about the matter. In an article posted in June 2009, Factcheck explained why even if we eliminated all health insurance company profits and all CEO compensation it would make little difference in solving our nation’s health care problems. As an example, in 2007, the CEOs of the top ten publicly traded health insurance companies earned about $119 million in total compensation. While this seems like a huge number, it actually represents only about 0.005% of the nation’s total health care spending of $2.2 trillion. The profit of those ten companies was $13 billion, only 0.6% of yearly spending. Furthermore, a 2008 study by PricewaterhouseCoopers determined that these profits represent only about 3% of the total cost of heath insurance. The vast majority of health insurance costs were due to benefits paid out (87%) and other administrative costs (10%) such as claims processing, consumer services, provider support, marketing, and government compliance. As we’ve seen, there are a number of reasons why health care in general, and health insurance premiums in particular, are fast becoming unaffordable. But as these numbers show, insurance company profits and CEO compensation have little to do with it.
Other Complaints about Health Insurance Companies
Two other criticisms are often leveled at health insurance companies. The first is that insurers don’t actually make anyone well; that they are simply unnecessary middlemen who add to the price of health care. From the discussion above, it should be of no surprise that I partly agree with this statement. For routine health care services, insurers are superfluous and unnecessary. The “insurance” they provide is really a pre-paid medical care program which drives up the cost of health care and interferes in the transaction between service provider and consumer. We must recognize though, that this system was created and fostered by government policies. Furthermore, a majority of consumers enjoy being insulated from the real cost of their annual health care expenses. We’ll talk about this further in part four, but for now I’ll simply state that it’s somewhat disingenuous to criticize insurers for being unnecessary middlemen while at the same time reaping the benefits of their interference. Where the above statement about “unnecessary middlemen” is untrue, is when health insurance protects us against catastrophic injury or illness. As I’ve described, insurance generally works well for the purposes for which it was intended. No one complains that companies that provide home or auto insurance are “unnecessary middlemen” because we instinctually recognize that in these instances insurers serve a critical function by administering the risk pool so we may be shielded against losses that we could not bear on our own. So, too, it is true for the “real insurance”, the catastrophic insurance, which is provided by health insurance companies.
Second, health insurance companies are criticized because supposedly their business model gives them an incentive to deny claims in order to increase profits and they take advantage of this every chance they get. On the surface, this might seem a valid complaint, and there are certainly instances where this has been shown to be true. But the reality is that these types of incidents are the exception rather than the rule. As the PricewaterhouseCoopers study shows, profits only account for about 3% of the cost of insurance and fully 87% of what health insurance companies collect in fees, they pay out in benefits. And as the study further details, this profit percentage has remained fairly constant over many years. If denying claims played a significant role in insurance company profits, we’d see that reflected in the statistics. Unfortunately for those that would like to believe that this practice is widespread, the numbers do not support that conclusion. Furthermore, a similar criticism could be leveled at any insurance company, not just health insurers, because the same incentives exist in their business models as well. Yet we rarely hear of public outrage against most other types of insurers as a whole, although isolated cases of claims denial abuse certainly exist. Insurance is simply a contract, like any other, that requires both parties to perform based on some pre-agreed upon terms. When one party fails to live up to their end of the bargain, then the full weight of our civil and criminal justice system should be brought to bear. But the fact that some players might be tempted to game the system does not mean that there is an inherent flaw in the business model, or that an entire industry is corrupt, or that the free market doesn’t work when it comes to health care.
46 Million People in the U.S. are Uninsured
Finally, no discussion of health insurance would be complete without mentioning the roughly 46 million people in the U.S. who are uninsured. This number represents about 15% of the US population and has been used as a rallying cry by those calling for health care reform. At a town hall meeting in New Hampshire on August 11th, President Obama repeated this number, saying,
“Now, health insurance reform is one of those pillars that we need to build up that new foundation. I don’t have to explain to you that nearly 46 million Americans don’t have health insurance coverage today. In the wealthiest nation on Earth, 46 million of our fellow citizens have no coverage. They are just vulnerable. If something happens, they go bankrupt, or they don’t get the care they need.”
If I was there, I might have been tempted to call out, “You lie!” or perhaps just politely point out that using this figure in this way is misleading and disingenuous. Here’s why. First, the number of 46 million does not represent only “Americans”, it includes people living in the United States who not yet American citizens and some who are here illegally. Second, the figure represents everyone who has been uninsured at any time over the previous year, meaning that even if someone is uninsured for as little as one day, they get counted as part of the 46 million who are uninsured. That certainly doesn’t mean that, “If something happens, they go bankrupt, or they don’t get the care they need.” Finally, it’s not clear that the number is even 46 million. That figure comes from the U.S. Census Bureau, which makes an estimate based on an annual random survey. However, according to Politifact, the U.S. Department of Health and Human Services also estimates the number of uninsured, but they use surveys of people conducted every few months to see if they have insurance or not. This method, which may be more accurate, found the uninsured population to be 40 million, not 46 million.
In order to determine whether we need to reform our heath care system and what those reforms might be, the question we should be asking is, how many Americans and legal immigrants who wish to buy insurance can’t afford it or are excluded due to pre-existing conditions. Let’s see if we can come up with a good estimation.
First, the Pew Hispanic Center, a nonpartisan research organization, estimates that there are about 6.8 million illegal immigrants in the U.S. that do not have health insurance. Since no health care reform plan would cover any of these people, in making the case for reform, they can’t be counted in the total number of uninsured.
Another 14 million of the 46 (or 40) million uninsured are already eligible for existing government programs such as Medicaid and State sponsored health care programs. They are not aware that they qualify for aid or simply wait until they need it before they sign up. Again, no health care reforms are needed to assist these people; they’re already covered.
Next, according to the Census Bureau, nearly 10 million uninsured Americans have household incomes of at least $75,000. Most can probably afford health insurance but choose instead to pay out of pocket when they need medical care. It’s possible, however, that some in this group would buy health insurance, but can’t, due to some pre-existing condition. Let’s say that about a third of this group would buy insurance but are prevented from doing so. That leaves about 6.7 million people who make over $75,000 and are voluntarily choosing not to buy health insurance.
Another group to consider is younger adults who, perhaps misguidedly, feel they’re healthy enough to go without insurance and that the potential benefits do not justify the expense. Based on census data, 13.7 million people aged 19 to 29 had no health insurance in 2006. Again, not all of them are choosing not to buy it. Some can’t afford it and some have pre-existing conditions. Again, let’s say 1/3 of this group falls into that category, so we’re left with about 9 million 19 to 29 year olds who are voluntarily opting out of purchasing health insurance. To be fair, some in this group also make over $75,000 and we’ve already counted them, so let’s reduce the number further to 6 million.
Now taking the Census Bureau’s higher number of 46 million uninsured, and subtracting off the 6.8 million illegal immigrants, the 14 million who qualify for coverage under existing programs, the 6.7 million who make over $75,000, and the 6 million 19 to 29 year olds who voluntarily opt out, we’re left with about 12.5 million people who need health insurance and can’t get it due to price, pre-existing conditions, or some other reason. That’s 4% of the population.
Again, for those of you who think I’m fudging the numbers, a Kaiser/ABC News/USA Today survey that looked at the issue from a slightly different perspective found that only 8.4 million uninsured Americans are either dissatisfied or very dissatisfied with their health care.
The point of this exercise is not to calculate the exact number of those who would truly benefit from health care reform, but rather to show that the inflated figure of 46 million uninsured is really just a scare tactic. The number of US citizens and legal immigrants who want health insurance and can’t get it is far fewer than the rhetoric suggests. That’s not to say that there aren’t some sensible, targeted reforms which could be implemented to alleviate many of the problems in our health care system and we’ll take a look at these in part four.
But first, a short discussion of the Pharmaceutical Industry in part three of health care reform.
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