It is more than passingly ironic that the representative animals of American Republicans (the elephant) and Democrats (the donkey) are both the offspring of a 19th century cartoonist - Thomas Nash. Were he alive today, Nash might have a great deal of fun depicting these two ungainly beasts attempting death defying arabesques, pivot turns and scissors leaps on the highly greased balance beam that is health care reform. Both portly quadrupeds agree that Obamacare needs fixing. But the nature of that fix remains the cause of a great deal of unhelpful snorting, grunting, and braying.
Too bad they don’t realize that the key lies in appreciating a type of market failure known to economists and other pointy heads as “adverse selection”. Prepare to be initiated.
One of the overriding goals of Obamacare (and one ostensibly supported by both Republicans and Democrats) is to ensure that those with pre-existing medical conditions have access to affordable healthcare. Under Obamacare, this is achieved by compelling insurers to lump those with pre-existing conditions into the same pool as those without – while charging everyone the same price. This has resulted in what is effectively a government mandated market failure, whose outward manifestations are skyrocketing health care premiums and market withdrawals by multiple insurers.
Adverse selection is a sorting problem. It arises when insurers cannot distinguish between good and bad risks. Suppose, for example, that those offering automobile insurance cannot distinguish between good and bad drivers, and set one price for all. Good drivers, who know that they are unlikely to have an accident, find the insurance expensive, and many will forego insurance. But for bad drivers, who know that they are likely to have an accident, the insurance looks like a bargain. Most of this ilk will thus buy the insurance. The result is that the pool of insureds is skewed toward high risk drivers. As a result, insurers’ payouts will be higher than initially forecast and the insurance companies will raise their premiums. But this merely triggers another round of the same phenomenon, with more relatively good drivers dropping out. Through successive iterations of this process, either premiums end up at nosebleed levels, or the market disappears altogether. The problem results from lumping low and high risks together in a single pool.
Mandating that insurers charge the same premiums to those with and without pre-existing conditions results in exactly the same phenomenon. People with pre-existing conditions cost insurance companies more money. What sane for-profit enterprise, left to its own devices, would set one price for customers with and without pre-existing conditions? If constrained to do so, the more enlightened among the policy wonks would predict that insurers will either raise premiums to a prohibitive level, or simple exit the market. This is exactly what has happened under Obamacare.
There are also distributional consequences to mandating that insurers charge a single price, since it forces healthy customers to subsidize the greater health care costs of those with pre-existing conditions. This is addressed in part under Obama’s Affordable Care Act by the provision of government subsidies for middle and low income people who purchase private health insurance. But this does nothing to address the robust adverse selection dynamic that the scheme has spawned.
The simple solution? Allow insurers to freely allocate customers into whatever risk pools they choose, and charge differential premiums depending on the level of risk. While it might appear that this will throw people with pre-existing conditions under the bus, these people can be accommodated by the government paying subsidies that cover the added insurance costs resulting from pre-existing conditions. This solution allows the private insurance market to operate free of adverse selection, while ensuring that those with pre-existing conditions are not left out in the cold.
There are a number of additional considerations that come into play. Poor people, who cannot afford to buy health care insurance at any cost, should be fully subsidized. Above that threshold, there is a danger (quaintly known to the pointy heads as “moral hazard”) that a full government subsidy for pre-existing conditions creates an incentive to engage in risky behaviour such as smoking or hanging by the teeth above Niagara Falls, knowing that any adverse health care costs will be fully covered. This can be addressed by making the government subsidy for pre-existing conditions less than 100%, in order to create some measure of risk sharing (with exceptions for people with involuntary conditions, such as genetically based illnesses, that do not engage moral hazard concerns).
In addition, in order to give people an incentive to shop for a low cost insurer (and a corresponding incentive for insurance companies to quote competitive prices to their prospective customers), the subsidy should be based not on the plan actually purchased, but on the cost of an ascriptive plan that mimics a competitive market outcome. In order for the government to intelligently set prices for ascriptive plans, while accommodating consumer preferences for different levels of health care insurance, it might be necessary to mandate that insurance companies offer a standardized suite of insurance products to those with pre-existing conditions. This will have some adverse impact on competition and innovation. However, insurance companies would still be free to engage in product differentiation and innovation in relation to non-subsidized plans, the benefits of which can be built into subsidized plans.
On a final note, a plan of this nature has another favourable distributional outcome. Currently, it is only those who purchase private health insurance plans who subsidize people with pre-existing conditions. Under the plan I have suggested, that cost is borne by all taxpayers. This not only spreads the burden more widely, but does in a progressive fashion (since the cost is borne proportionately more by the wealthy than by the poor because of graduated marginal tax rates).
While of late Republicans and Democrats have not found it easy to play well together, perhaps there’s something in this for everyone. Republicans can rejoice in the efficiency of removing non-market based restraints on insurance companies, while Democrats can celebrate the preservation of Obamacare and the superior distributional outcomes. This might just ungrease that perilously slick balance beam, and allow both elephants and donkeys to execute flawless full twisting back handspring discounts, and proceed to another piece of apparatus (tax reform?).
