Health-Status Insurance: How Markets Can Provide Health Security
by John H. Cochrane
None of us has health insurance, really. If you develop cancer or heart disease, have a stroke, or discover a genetic problem; if you have any long-term disease; if you then lose your job, are divorced, or just outgrow your parents’ plan, you can lose health insurance. You now have a pre-existing condition. Insurance will be enormously expensive if it’s available at all. This fact is, I think, the single most powerful force pushing us toward some sort of nationalized health insurance system or additional layers of intrusive regulation.
There are three keys to letting markets provide long-term health insurance. First, we must remove restrictions on risk-based premiums, so that sick people pay higher premiums than healthy ones. Second, and most critically, we must clear the way for markets to offer “health-status insurance” which, in exchange for an upfront payment, will give people the money to pay higher medical-insurance premiums if they get sick. The bulk of this article describes in detail how the combination of medical and health-status insurance works, how it how it could provide truly lifetime, portable insurance, and how it would foster an unprecedented level of competition in health care, even for the sickest of patients. Third, we must remove the legal and regulatory artifacts that favor employer-based insurance or other long-term pools over individual-based insurance.
These steps are the opposite of most current policy proposals, which would further limit risk-based pricing, force insurers to take all comers, strengthen employer-based or other pools, or introduce national health insurance. Those proposals can only help to solve the long-term insurance problem by destroying market competition – the only force that can continuously deliver better medical care at a lower cost.
John H. Cochrane is the Myron S. Scholes Professor of Finance at the
Health-Status Insurance: How Markets Can Provide Health Security
by John H. Cochrane
None of us has health insurance, really. Most Americans have an employer-provided health plan, or have that coverage through a spouse or parents. But if you get cancer, heart disease, HIV, have a stroke, discover a genetic defect, or develop any other long-term expensive health problem; if you then lose your job, are divorced, or just outgrow your parents’ plan, you can lose that health insurance. You now have a pre-existing condition. Insurance will be enormously expensive if it’s available at all. This happens, to real people. A significant health problem is a common root cause of catastrophic economic descents in the
This fact is, I think, the single most powerful force pushing us toward some sort of nationalized health system, or additional intrusive regulation of health insurance and delivery markets. There are plenty of other pathologies with our health sector: the uninsured, hospitals’ hotel-minibar pricing policies, poor information, the drudge of useless paperwork, cost recovery of new medicines, and so on. But all of these are fairly clear problems, each limited in its reach, with fairly clear remedies. The lack of real insurance, by contrast, seems a harder nut to crack. Unlike the uninsured, which for most of us is a problem of how to deal charitably with other, improvident people, the lack of real insurance confronts us all. No matter how prudent you are, you cannot buy insurance against long-term health risks.
Is there really no free-market remedy? Is the only answer to rely on the government to provide health insurance, or to have the government intervene even more massively in private contracts? The answer is no, and my main purpose here is to outline how deregulated insurance markets can cover lifetime health risks.
There are three keys to letting markets provide real lifetime health insurance. First, all levels of government must allow insurers freely to charge sick people higher premiums, and healthy people lower premiums. This is exactly the opposite approach of much existing regulation and most health-care reform proposals, which try to force insurers to take all comers at the same price. Such regulations lead insurers to avoid the sick, and overprice insurance for the healthy. Insurance companies refuse coverage, deny preexisting conditions, or more subtly avoid or mistreat sick people, only when they can’t charge those people enough to cover their costs. If they can charge enough, they’ll cover anyone and compete for their business.
Second, and most critically, we must clear the way for markets to offer “health-status insurance,” so that people who become sick will have enough money to pay higher premiums.
Much current regulation and many policy proposals instead attempt to strengthen employer-provided health insurance in various ways, so that the premiums of the healthy can cross-subsidize the sick for long time periods. Since the above two keys would allow a private, individual-oriented health insurance market to work, the third key is to reverse this trend, so that individuals purchase lifetime insurance no matter where they work (or even if they don’t work), and so individuals have perennial ability to shop for better insurers rather than be tied to one pool or company.
Here’s how the combination of medical and health-status insurance can work. Each year, you purchase a medical-insurance policy that provides one year of coverage. The premium depends on your health status; premiums are higher for people with long-term expensive illnesses than they are for healthy people. The insurance company then pays your medical expenses for the year, less copayments and deductibles, just as now.
You also purchase a health-status insurance policy. Suppose that during the year you get a long-term illness that moves you into a more expensive medical-insurance premium category. The health-status insurer then pays you a lump sum equal to the present value of the cost of those higher medical-insurance premiums. With that lump sum, you can now pay higher medical-insurance premiums to your insurer or any other insurer, with no change in out-of-pocket expense.
Health-status insurance payments should be deposited in a special health-status insurance account that can only be used to pay medical-insurance premiums and perhaps certain medical expenses. (This provision is part of a private contract, not a necessary regulation.) First and most important, large lump sums are a temptation to fraud – get a fake disastrous diagnosis, take the money, and disappear. That’s much less tempting if all you can do with the money is buy medical insurance, from a company that will surely notice when your horrible disease suddenly vanishes. Second, if you can become unexpectedly healthier (i.e., if medical insurers’ premium categories allow once-sick people to qualify for lower annual premiums when they recover), you should return part or all of the lump sum, since you no longer need it to pay higher medical-insurance premiums. (Contracts without this provision work, but this provision makes the contract cheaper.) This provision is much easier to enforce if the lump sum is placed in a dedicated account that operates like a private trust. Third, people who receive a large lump-sum payment may choose to spend it on other things and then show up in the emergency room, unable to pay their bills. It is in both consumers’ and insurers’ interest to pre-commit against this option, and doing so incidentally helps to solve a social and policy problem.
Health-status insurance accounts are not the same as health savings accounts. Health savings accounts are tax-preferred savings vehicles. You are allowed to withdraw money for some non-medical purposes and to pass the assets on to heirs, as well as to pay for medical expenses. Health-status insurance accounts implement an insurance contract. They are funded by health-contingent payments from the health-status insurance company, and ideally they should not be inheritable or used for any other purpose.
However, the institution of health savings accounts is a great first step, as it establishes the legal and regulatory framework for accounts that are limited in some ways to health payments. Now, markets need only create a variant of something that exists, rather than something totally new.
Competition and Freedom
Such contracts would solve the central problem with our current health insurance market: the lack of real health security. You can be insured for life, no matter if you lose your job, are divorced, grow up, move, take some time out of the labor force, and so forth.
Even more important than security, this system would give great freedom to each individual. No matter how sick you are, you would be completely free to take your health-status insurance account and change medical insurers, change jobs, move, and so forth. You could always afford the higher premiums a new insurer will demand, just as easily as you could afford pay the higher premiums your current insurer will require. You would not depend on the good treatment of one insurer, or the vagaries of one pool, the link to one employer, or one government-provided plan -- you can always leave with your health-status insurance account and find something better.
Freedom for consumers would force much greater competition among medical insurers and medical-care providers. Medical-insurance companies would compete for the business of sick, expensive, high-premium customers, rather than try to get rid of them, or “contain their costs.” Where current policy proposals would limit healthy people’s choices (to keep them around and subsidizing the expenses of sick people), medical-insurance companies would freely compete for healthy people too, offering them better service or lower premiums. Constant competition for every consumer will have the same dramatic effects on cost, quality and variety of service in health as it does in every other industry.
Suppose a healthy 25-year old male will incur $2000 worth of medical expenses in a year, on average. This average includes a large probability of no medical expenses, but also small chances of substantial expenses. A competitive medical-insurance market will offer him insurance with a $2,000 premium, plus administrative costs and profit.
Suppose that, along with potential short-term illnesses, he has a 1 percent chance of developing a chronic condition that will raise his average medical expenses to $10,000 per year. Again, this number averages over all the possibilities, but it is the actuarial average for people with this condition. If he develops the condition, a competitive medical-insurance market will still cover him in following years, but his annual medical-insurance premium must rise to $10,000, plus costs and profit. This would be a large financial setback.
Suppose he only wants medical insurance until age 65, when he will transition to Medicare. To really be insured, then, he needs a lump sum payment to be deposited into a health-status insurance account, enough that the account custodian can pay $8,000 per year of extra medical-insurance premiums for the subsequent 44 years. At a 5-percent interest rate, that sum would be $148,370.  Therefore, his initial outlay will have to include 1 percent of that value ($1,483.70) per year, plus administrative costs and profit, as a fair premium for health-status insurance.
In sum, he pays $2,000 for one-year medical insurance, plus $1,483.70 for health-status insurance, for a total of $3,483.70 in out-of-pocket expense. Now he is completely covered, both for short-term and for chronic medical expenses. He is also free to change medical insurers at any time, with no change in out-of-pocket expenses.
This example is simplistic, of course. Bradley Herring and Mark Pauly use data on the incidence of a long list of chronic diseases to provide a realistic estimate the sum of medical- and health-status insurance premiums. Their annual medical-insurance premium for a low-risk individual rises from $800 at age 25 to $3,038 at age 55; while a high-risk person would pay $2,300 at 25 rising to $10,023 at age 55. Clearly, jumping from low-risk to high-risk implies a large financial penalty. Ignoring health-care cost inflation, they estimate that the combined medical- and health-status premium would start at $871 at age 25 and rise to $3,936 at age 55. These amounts are surprisingly close to the one-year medical-insurance premium charged to low-risk people, only $71 more at age 25 and $898 more at age 55. Transitions to high-risk are in fact rather rare, especially early in life. Total premiums in their calculation also rise uniformly with age, unlike in my example. This fact reassures us that young healthy people, who typically have lower incomes than later in life, will not shy away from health-status insurance due to a front-loaded payment stream.
Guaranteed-Renewable Health Insurance
Why don’t we just change insurance so that you can’t be dropped for getting sick, and you always have the right to renew at a preset rate? With insurance like that, it would seem the problem would go away. This is “guaranteed-renewable” health insurance. It is the other major vision for how a free market could insure people against long-term risks. In fact, it is already available. Life insurance is usually guaranteed-renewable. Individually-purchased health insurance must now be guaranteed-renewable, and 75 percent of policies were so even before the mandate was passed. The only reason more of us don’t have it is that we have been prodded by taxes and regulation into employer-provided insurance.
Does guaranteed-renewable health insurance work? One worries that once you become sick, the insurance company is going to lose money on you for the rest of your life, and has every incentive to treat you badly or try to get rid of you. However, perhaps this is not such a huge problem. The effects of reputation and our legal and regulatory system may be strong enough to enforce long-term contracts on large companies. A deeper problem is that healthy people will want to leave. After we find out who is sick and who is healthy, the insurance company cross-subsidizes sick people’s expenses from healthy people’s premiums. Therefore, another company can offer healthy people a better deal. But if the healthy leave, the original insurer will go out of business, and therefore won’t end up insuring anyone. It is neither realistic to force (healthy) consumers to stay with one insurer for their entire lives, nor would it be possible to enforce such contracts, and guaranteed-renewable health insurance does not try to do so. Much existing policy and many proposals instead try to limit health-insurance competition in order to take away healthy consumers’ freedom to find a better deal.
However, this problem can also be solved with a sufficiently clever insurance contract. Mark Pauly, Howard Kunreuther and Richard Hirth show that you can structure a guaranteed-renewable contract so that nobody ever wants to leave, at least for financial reasons, by charging everyone the same price that is charged to the lowest-risk person. Herring and Pauly find some evidence that individual health insurance premiums reflect some of this feature.
In my illustration, suppose you can develop the chronic condition once at age 25 only. After that, you’re either sick forever, costing on average $10,000 per year, or healthy forever, costing on average $2,000 per year. The medical- and health-status insurance payment I analyzed above is then $3,483.70 in the first year and $2,000 per year thereafter for everyone. The average medical costs for all individuals are, for every year of life. A conventional “guaranteed-renewable” policy would therefore charge $2,080 per year. This would fall apart in a competitive market, however, since after the first year all the healthy people could be wooed away by a competitor charging $2,000 per year. If insurers were instead structured the guaranteed-renewable policy to charge everyone $3,483.70 in the first year and $2,000 in every following year, no one could woo away the healthy people ex-post. Pauly et al. call this an “incentive-compatible” guaranteed-renewable contract. By the same math as above, the insurance company breaks even. Therefore, no one can woo the healthy away ex-ante either with any other incentive-compatible contract.
The example shows an important point in comparing health-status insurance and guaranteed-renewable insurance: The premiums of any incentive-compatible guaranteed-renewable insurance contract are exactly equal to those of a sequence of medical-insurance and health-status insurance contracts.
A health-status insurance contract is no more than a guaranteed-renewable contract in which the insurance company periodically “marks to market” its long term obligations to the consumer, or the two parties occasionally “settle up.” At the end of the first year in a guaranteed-renewable contract, the insurance company’s accountants should look at each patient with the long term illness and say “this person is going to cost us $8,000 per year. We should write down the company’s value by $148,370.” In the health-status insurance model, they instead actually pay out $148,370 and now have no more obligations.
Though the contractual difference is small, the implications of periodically settling up a long-term contract are profound. After this settling up, both sides are free. The consumer does not depend on a continuous tie to one insurance company to provide medical coverage for the rest of his life. Freedom to leave is a much more effective way of keeping insurers and providers on their toes than are reputations, long-term contracts, and courts. The guaranteed-renewable and medical-plus-health-status insurance models are similar. Health-status insurance, however, could provide greater freedom to healthy and sick consumers, would force insurers to compete for sick consumers, and would ensure that no consumers would be stuck with an insurer they find objectionable.
However, guaranteed-renewable insurance is a great start and probably provide the best stepping stone to the end result. Health-status insurance as I have described it seems like a radical innovation. It seems to require reversing a half-century’s worth of regulation, on the hope that some totally new system will work. Yet we can gradually free this market without taking any big leaps into the unknown.
Greater emphasis on guaranteed-renewable individual insurance, which already exists, is the natural first step. Restoring insurers’ freedom to risk-rate their offers will make guaranteed-renewable insurance more “incentive-compatible” and force insurers to compete for all customers. (I discuss below how to help high-cost individuals who could see a spike in their premiums during the transition period.) Demand from consumers who want the freedom to change insurers will push the next step, in which insurers add “marking to market,” or periodic settling-up clauses, and health savings accounts are slightly modified to become health-status accounts and carry the payments.
Each step can coexist with the last. In particular, since health-status insurance just makes a small modification to guaranteed-renewable insurance, rather than create an alternative scheme, competition can easily sort out just how much health-status insurance is optimal, i.e. how to and how frequently to settle up. There is no need for regulators or policy wonks to decide between the two visions. Over time, deregulation and market innovation can gradually and seamlessly create fully portable, long-term health insurance.
The contracts I have described, combining one-year medical insurance and health-status insurance with payments held in a custodial account, show most cleanly how the contract works. Markets may devise other ways to achieve the same end, however, and it is not my intention here to design the exact formulation and marketing plan that will be most attractive to consumers, insurers, and regulators.
Health-status insurance can be handled by a separate company. Since this is largely a financial transaction, a financial services company might be able to handle it better than a medical-insurance company. On the other hand, consumers might prefer to have the two forms of insurance bundled as “long-term health insurance” and not worry about two separate contracts.
The health-status insurance account does not have to be settled every year. You could have a guaranteed-renewable medical-insurance policy, and a health-status account is created or updated when you want to leave. On the other hand, with insurance as in all human relationships, there is less chance of fighting between consumers and insurers if the settling-up is done more frequently and in smaller chunks than in one large chunk after the consumer has already decided to leave.
The health-status account really isn’t even necessary. You could just have a “transferability” right. Your current insurer would agree that, when you want to leave, it will pay a lump sum to any new insurer, such that new insurer will now be willing to take you in a plan of similar quality with no change in out-of-pocket expenses. The sum could be the same sum that your current insurer charges to take on a new customer of your age and health status. That obviously would not give consumers quite as much freedom as a health-status insurance account with real assets. But it could work almost as well in practice and might be simpler for people to understand.
Alternatively, rather than have an account with a dollar figure in it, health-status insurance could simply promise to pay any additional medical-insurance premiums over a set amount, as long as you’re alive (or until Medicare eligibility). The exact kinds of payment would have to be spelled out in some detail, either by specifying the qualifying plans or by specifying how much extra will be paid out for various risk conditions, but that’s fairly straightforward in practice. In this implementation we don’t have to worry about the insurer retrieving lump-sum payments if you get healthier. You would be dependent on a long-term contract, but it is much more reliable to receive an annuity from a financial services company than it is to rely on a long-term promise by a medical-insurance and delivery company. Plus, you still could have the right to choose any medical insurer you want.
Changing Tastes and Quality
Suppose you purchase a bare-bones medical plan and health-status insurance that pays for a change in the present value of the bare-bones plan premiums. You contract a high-cost condition. What if you then decide you want to move to a better medical plan, one that charges substantially more?
Insurance can cover external misfortune, but it can’t cover changing tastes. If you want to move to a fancy plan, you’re going to have to pay more. However, you could buy, and companies could sell, bare bones medical insurance and a health-status plan that covers changes in fancy medical-plan premiums. That will cost a little bit more, but when you get sick, a much larger sum would be deposited in your health-status insurance account. This would be an attractive option for young people or people in temporarily reduced circumstances. Home and car insurers will not let you be “overinsured,” declaring too high a value, for obvious incentive reasons. But there is no such worry with health-status insurance since you can’t do anything but buy medical insurance with the payouts.
Premium Categories and Contract Simplicity
More generally, in the real world we don’t have to insure people down to the last dollar, so it is not necessary to key health-status payments precisely to an individual medical plan’s exact schedule. Home insurance markets work, even though the payment is never equal to the exact value of the home. Health-status insurance companies could offer three or four levels of coverage, keyed to surveys of the costs of three or four standard levels of medical coverage. Similarly, medical insurers would probably have a short number of classifications, say a 1-10 scale of “low risk” to “high risk”, rather than publish a premium schedule for every conceivable disease history. This would make their job and the health-status insurer’s job much easier at a small cost.
I have also emphasized the theoretically perfect case that health-status insurance pays precisely the annuitized lifetime present value of the expected change in premiums. Really, though, any large approximate payment will do, especially if the premium insurer can recover unused funds at death or if the consumer becomes healthier. A health-status insurance contract could then simply have a schedule of preannounced payments, “pays $50,000 if you are reclassified from category 3 to category 5,” with $50,000 the advised level of coverage for someone in a A- level plan. People could freely choose a better contract, say one that pays $70,000 in this event, the advised level for A+ plans, at a slightly higher cost.
The main disadvantage of health-status insurance relative to lifetime guaranteed-renewable insurance is the contracting cost of establishing how much the severance payments should be, and deciding when to make them. In these ways, however, the contracting costs could be quite small and the procedure quite efficient if, as with home insurance, people can tolerate some minor slippage.
Health-status insurance has another strong advantage over most other proposals: it provides long-term security through any interruptions or changes in medical insurance. In a long-term pool or a long-term contract, as soon as you stop making payments you lose any right to low premiums and the treatment of your now preexisting conditions, thus losing the implicit coverage for long-term illness.
This happens. For example, people who lose their jobs often have the right to continue health insurance, at least for a short time, if they pay the entire premium including what used to be the employer’s contribution. But people who just lost their jobs often have trouble paying premiums, especially if the job loss coincides with an expensive illness. People who take time off from work to raise a family, or lose their connection to health insurance through divorce don’t even have the right to continue coverage and are in even worse positions.
By contrast, anyone with health-status account can switch to a lower-cost medical plan, or miss some period of medical coverage entirely, to adapt to economic misfortune, and retain protection against the costs of their long-term illness. When they’re ready to reestablish medical insurance, or move back to a better and more expensive medical-insurance plan, the health-status account is there and waiting.
Lifestlyle Choices – Smoking, Weight, Drugs, and so forth.
Some potential indicators of long-term health are to some extent under people’s control – weight, exercise, smoking, drugs, risky sexual behavior, and so forth. If people do not suffer the financial costs of these choices themselves, they will have less incentive to behave well. That will make insurance more expensive for everyone, suboptimally reduce public health, and potentially price people who know they will behave well out of the market.
This “moral hazard” is a problem for all forms of insurance, including guaranteed-renewable health insurance, and health insurance provided by government or employers. Nevertheless, it is still worth thinking through what moral hazard means for health-status insurance.
Allowing medical insurers to charge different amounts based on health status, and to adjust premiums annually would help reduce moral hazard. If insurance costs more for smokers, people who are overweight, or if premiums depend on blood sugar or blood pressure readings, people would have a forceful annual reminder to do the right thing. Restricting insurers’ freedom to vary premiums eliminates the market’s ability to induce these healthy behaviors.
However, if you start to smoke and your medical insurer raises your rates, but your health-status insurer covers the difference, we’re back where we started. The natural answer is for health-status insurance simply not to insure events that are subject to moral hazard. Home insurance does not cover arson. The health-status contract could cover changes in health classification due to illness (cancer, stroke, etc.), but could refuse to cover those due to unhealthy behaviors (smoking, drug use, unhealthy weight levels, etc.). Better yet, it could make only partial payments into one’s health-status insurance account, to reflect the fact that some behaviors (e.g., weight gain) are not totally under people’s control. If the payouts to those customers’ health-status insurance accounts are less than the surcharge that insurers impose, then those unhealthy behaviors would still trigger an annual but manageable reminder that the customer should take better care of himself. Alternatively, the health-status insurer could offer full coverage for all health-classification changes and charge higher premiums for unhealthy behaviors itself.
This lack of complete insurance is a strong argument for premium insurance, as opposed to employer-purchased or government-provided insurance. The latter two remove most of the financial incentives to maintain even easily observable determinants of good health. We shouldn’t insure everything.
What about People Who Are Already Sick?
Private markets cannot provide insurance against events that have already happened. You can’t say to an insurance company, “My house just burned down. How about home insurance?”
Many people feel that government should provide insurance against events that have already happened, especially when no insurance was available so the unfortunate are in some sense blameless. If so, health-status insurance, with health-status insurance accounts, offers a very clean way for the government or private charity to help people who are already sick. Either could deposit the appropriate lump sum in an individual’s health-status insurance account and then get out of the way. This is much more straightforward, flexible, and less distortionary of insurance markets than directly providing coverage in a government-sponsored health-insurance plan, or forcing private insurers to take such patients as part of a forced pooling arrangement.
Still, this consideration is most important at startup, when long-term insurance first becomes available and we can’t realistically expect people to have bought any. Once it is instituted, parents can buy family insurance that provides for individual premium insurance accounts for their children. Then, children who develop rare long-term diseases will still be covered for life without needing government interventions. Premium insurance can potentially apply to unborn children, and thus privately cover genetic defects from birth.
What about Adverse Selection?
People who know they are sick and can hide it tend to buy more insurance, which can cause insurance markets to unravel. Realistically, adverse selection is not that much of a problem for health insurance markets. True adverse selection refers to things patients know that the insurer cannot know – what economists call “asymmetric information.” Does a patient who knows his or her aches and pains really know more than can be learned by looking at his or her entire medical history and a careful exam? (Hiding a history is fraud, and can invalidate a contract.) When we now observe only sick people signing up for insurance it seems like adverse selection but it is not. It is the result of artificially forbidding insurers from charging more for people that everyone knows are going to be expensive, not a fundamental information problem that would stop a deregulated market from emerging. Markets with blinders on cannot see.
As in current health and life insurance, health-status insurers would mitigate adverse selection by charging higher premiums to people who are more likely to get long-term illnesses, and could refuse to cover premium increases triggered by certain conditions that appear in the first few years of a contract. You still have to buy insurance before your premiums increase. Markets cannot insure people after the fact. This fact does not mean we’re back where we started. In a premium-insured world, you have to buy health-status insurance before you find out if you have a long-term illness. In our world, most health insurance does nothing to help healthy people insure against developing a long-term illness.
Adverse selection is exactly the same for health-status insurance as it is for lifetime insurance with a single company. The portability engineered by lump-sum payments doesn’t make adverse selection any better or worse. So at a minimum, this isn’t a special issue for premium insurance.
Employer-Provided Insurance and Forced Pooling
I have described so far an individual insurance contract, ignoring the fact that most insurance is now provided by employers. For some purposes this distinction does not matter. It doesn’t matter if an individual or his or her employer pays the medical or health-status insurance premiums. It doesn’t matter if the employer provides medical insurance. It does matter that if the individual gets a long-term illness; that he has individual health-status insurance (which can also be paid by the employer); that health-status insurance payments are made to the individual’s health-status insurance account; and that this account is, like a defined-contribution retirement account, entirely portable, so that a sick person who leaves employment can afford higher premiums.
However, the structure of most current employer-provided insurance is anathema to market-based insurance. Most current employer-provided health insurance involves forced rather than voluntary pooling. All employees pay the same nominal premium, both directly and through employer’s contribution on their behalf. Thus, employer-provided insurance attempts to force healthy workers to cross-subsidize sick workers and their families. Why don’t healthy people leave, as another insurer can offer them a better deal? Crucially, they can’t leave. You cannot ask your employer to direct his contributions to an individual plan, and you can’t take your own pretax contributions either. This can’t be changed without threatening employment-based coverage. If the healthy people could take their contribution, and their “employer contribution,” and buy cheaper or better insurance, no one would be left to cross-subsidize the sick.
Forced long-term pooling is the primary alternative to health-status insurance for providing long-term insurance. It is not a market solution – it requires extensive government intervention. It requires severe limits on competition between insurers, to bind the healthy to their pool of sick people, and thus begets poor service. It requires intrusive regulation to ensure that insurers don’t “contain costs” by cutting back on services for sick people, and it guarantees that nobody will be competing for their business. Forced pooling will always be imperfect, as people change any pool we can think of forming over their lifetimes, and it’s not obvious that being forced into one pool for life is desirable anyway.
Forced pooling is the heart of most health-care “reform” proposals – whether strengthening employer-provided insurance, creating pools based on geography as in the original Clinton proposal, forcing insurers to take all comers at the same price, assigning high risks to insurers, eliminating competition for healthy customers, or in the end stuffing us all into a single pool of nationalized health insurance -- to which the healthy must contribute, and from which they cannot escape -- with no choice or competition at all.
In this sense, health-status insurance is the exact opposite of most health-care reform proposals. It really doesn’t matter whether an employer or an individual purchases the health insurance. What matters is whether we provide long-term health security through forced pooling and the force required to eliminate competition, or through free exchange.
What Needs to Be Done
It’s easy for an economist to describe health-status insurance contracts coupled with a health-status insurance account. Allowing them to emerge in the real world, on the other hand, will require changes to the legal and regulatory framework of health insurance markets. As usual, removing current regulations is more important than adding new ones.
Encourage Risk-Based Premiums
In an attempt to force the healthy to cross-subsidize the sick, regulations frequently restricts insurers’ freedom to adjust premiums according to new or current customers’ health or to exclude pre-existing conditions. Even when those measures are not explicitly forbidden, insurers rightly fear that publication of a premium schedule explicitly based on health status would draw all sorts of political and regulatory ire.
Regulators need instead to encourage explicit risk-rating, so that anyone can get coverage (albeit at a price) and so that healthy people will not try to defect. Regulators need to encourage the publication of explicit premium schedules based on health risk, so that so that health-status payments can be calculated. It would help if insurance companies were to standardize somewhat the health levels that trigger premium changes, which might require some regulatory coordination.
Tax Reform and Employer-Based Plans
The tax-deductibility of employer-provided pooled health insurance, along with other regulatory and legal pressure in its favor, is one of the major distortions in the health-insurance market, and to blame for many of its problems. It is the reason that “insurance” pays for perfectly forecastable events such as annual checkups and shots, yet often does not provide true insurance. Employers have much less incentive to pick plans that take care of small-probability disasters for employees who will leave anyway in those events. Employers’ incentive is to attract and retain good workers. That is a much weaker mechanism for guaranteeing quality than people directly buying things that they need and will still need after they leave that job. The current dominance of employer-provided plans means that the individual market, where people buy their own insurance, is much smaller, more expensive, and consists of worse risks (many people too sick to get jobs). There is no more reason that everyone at your job should have the same health insurer than that they should have the same home or auto insurer. Insurance will be much better tailored to individual’s needs if that is not the case.
Where most policy proposals want to strengthen the unnatural link between employment and insurance, as a way to force people into pools, true long-term insurance will emerge more quickly if instead the tax-deductibility of employer-provided insurance and other regulation in its favor is eliminated. At a minimum, individually-purchased health insurance should receive exactly the same tax treatment, even for the increasing number of taxpayers snagged by the AMT, so that individual insurance can compete. Employees need to be able to direct employer contributions to the plan of their choice as well.
Once these policy paths are in place, long-term insurance can emerge naturally. No policy-maker needs to design the contracts and impose them on anyone. Once individual and group employer-based insurance are on an equal footing, the individual market will be revitalized, and employer-based pools will start to unravel, since healthy people will be more likely to leave. Employers will therefore be happier to fund individual insurance rather than try to operate pools. Once price competition is allowed, there will be pressure for contracts to adopt the “incentive-compatible” structure, to keep healthy people from defecting to competing insurers. Price competition and risk-rating of medical-insurance contracts also will give rise to a natural demand for health-status insurance. Neither feature exists now, because government largely forbids private insurers to compete for the business of sick people, and thereby forces insurers to avoid the sick by denying them coverage instead.
As I write in the Fall of 2008, the most relevant health plans to contrast with free-market health-status insurance are those provided by the presidential candidates.
Both candidates recognize that Americans lack the sort of health insurance that provides long-term security, and they recognize that this is an important, if not the most important problem with current health insurance. They both promise to fix it, but neither really has any idea how to do so. Senator Obama introduces a national health plan and grossly restricts competition among private insurers through a government-run “exchange.” Both candidates favor requiring insurers to cover pre-existing conditions. These steps go in exactly the wrong direction.
Clearly, neither campaign has ever heard of health-status insurance, or have any vision that a free and deregulated insurance market could provide long-term insurance, so neither is really for it or against it in any meaningful sense. It’s time that they did hear of it.
Barack Obama’s Health Plan
Sen. Barack Obama promises “portability and choice.” Americans “will be able to move from job to job without changing or jeopardizing their health care coverage.” He calls for “stable premiums that will not depend on how healthy you are,” and promises “No American will be turned away FROM ANY INSURANCE PLAN because of illness or pre-existing conditions.” These are important goals, and exactly what medical insurance plus health-status insurance would accomplish. Unfortunately, Sen. Obama’s proposals would not deliver the promised results, would prevent the market from doing so, and would undermine the competition on which quality and cost depend.
He proposes a National Health Insurance Exchange through which the federal government would ban pre-existing condition clauses and would force insurance companies to take everyone at the same price. As we have seen, this can’t work. Forced to pool, insurance companies still have strong incentives to avoid, get rid of, and “cost-contain” sick people, and to try to steal healthy ones away from competitors. Many healthy people would rather forego insurance than cross-subsidize sick people. Down this path, we have to force people to have insurance and force employers to provide it, and we have to eliminate consumer choice and competition between insurers. All of these steps appear in various health-care policy proposals. This path is a never-ending race of intrusive regulation against powerful financial incentives, to the detriment of competition.
The natural end of this race is to throw your hands in the air and adopt a national health-insurance system. Sen. Obama basically proposes this ultimate step:
Obama will make available a new national health plan [for] all Americans… The plan will cover all essential medical services, including preventive, maternity and mental health care [with] affordable premiums, co-pays and deductibles…The new public plan will be simple to enroll in and provide ready access to coverage… Individuals and families who…need financial assistance will receive an income-related federal subsidy to buy into the new public plan…
It is not mentioned how expanded coverage will be paid for by “affordable premiums,” and how an anti-competitive “exchange” and national health plan will achieve miracles of efficiency not matched by private industry, to say nothing of any government-provided service.
John McCain’s Health Plan
Sen. John McCain echoes the same goals. Some of Sen. McCain’s rhetoric and proposed reforms are somewhat more encouraging, and consonant with health-status insurance and the merits of competition. For example, the McCain campaign web site explains:
John McCain believes the key to health care reform is to restore control to the patients themselves… An important part of his plan is to use competition to improve the quality of health insurance with greater variety to match people's needs, lower prices, and portability… Families will be able to choose the insurance provider that suits them best… John McCain proposes making insurance more portable. Americans need insurance that follows them from job to job. They want insurance that is still there if they retire early and does not change if they take a few years off to raise the kids.
Some of Sen. McCain’s proposals could facilitate the development of health-status insurance. He proposes to replace the current tax break for employer-sponsored health insurance with a uniform tax credit for all health-insurance purchasers, as I advocated above. If an individual plan that combined medical and health-status insurance existed, at least people could choose it without penalty. He proposes to allow individuals to purchase health insurance across state lines. This proposal will increase competition, which helps to undermine forced pooling efforts. It would also increase regulatory competition between states to provide a consumer-friendly regulatory environment, which could include the regulatory innovations needed for rate discrimination and health-status insurance to emerge. It would also make the regulatory changes easier, since only one state need make the necessary changes for all Americans to have access to health-status insurance.
Unfortunately, Sen. McCain also supports insurance-pricing restrictions that preclude the development of health-status or other long-term health insurance. His campaign web site boasts, “FACT: John McCain supported the Health Insurance Portability and Accountability Act in 1996 that took the important step of providing some protection against exclusion of pre-existing conditions.” This goes in the wrong direction, towards forced pooling and away from a market solution. More generally, the McCain plan does not articulate a clear strategy that can achieve the admirable goals. Hint: here is one.
Any good economist looks for market failure before regulating something. Where is the market failure behind banning risk-based premiums and pre-existing condition clauses, and subsidizing employer-provided health insurance? No one has credibly documented something like natural monopoly, missing property rights, adverse selection, asymmetric information, or any conventional source of market failure motivating these interventions, or preventing the emergence of private long-term health insurance. At a minimum, we learn from the possibility of health-status insurance that they are none; that these are needless regulations rather than responses to a genuine market deficiency.
A completely private insurance market can solve the central problem of health insurance in
At a minimum, free-market economists no longer need to hem and haw, saying, “Well you have a point there, but do we have to make the regulation quite so intrusive?” We can instead say with confidence, “We can have long-term insurance with a completely deregulated health-insurance market, and here’s how.”
Of course, we can also hope that it actually happens: that our government takes the simple steps necessary to let long-term free-market health insurance emerge in place of highly regulated pooling systems. We could then watch with delight as the resulting competition does its usual magic of raising quality, lowering costs, and spurring innovation in both the medical and financial aspects of health care.
 The contracts in this article are described more fully, with all the equations you could ever want, and with responses to additional objections, in “Time-Consistent Health Insurance,” Journal of Political Economy 103 (June 1995) pp. 445-473.
 Herring, Bradley, and Mark V. Pauly, 2005, “Incentive-Compatible Guaranteed-Renewable Health Insurance Premiums,” 2005, Journal of Health Economics, 25, 395-417. As I explain below, the “GR” or guaranteed-renewable premiums shown in their Figure 3 and Table 3 are identical to the combination of health and health-status insurance payments described here.
 Mark Pauly and Bradley Herring, Pooling Health Insurance Risks (Washington: American Enterprise Institute, 1999).
Mark V. Pauly, Howard Kunreuther, and Richard Hirth, 1995, “Guaranteed Renewability in Insurance,” Journal of Risk and Uncertainty 10, 143-156; Mark Pauly, Andreas Nickel and Howard Kunreuther, 1998, “Guaranteed Renewability with Group Insurance,” Journal of Risk and Uncertainty 16, 211-221.
 Herring, Bradley, and Mark V. Pauly, 2005, “Incentive-Compatible Guaranteed-Renewable Health Insurance Premiums,” 2005, Journal of Health Economics, 25, 395-417.
 See Mark V. Pauly and Robert D. Lieberthal, “How Risky Is Individual Health Insurance?” Health Affairs Web Exclusive w242, May 6, 2008, http://content.healthaffairs.org/cgi/reprint/hlthaff.27.3.w242v1.pdf.
 All quotes are from Obama ‘08, “Barack Obama’s Plan for a Healthy America: Lowering Health Care Costs and Ensuring Affordable, High-Quality Health Care for All,” p. 7, http://www.barackobama.com/pdf/HealthPlanFull.pdf (accessed September 2, 2008).