Tuesday, July 7, 2009

Health care: What's the role of heterogeneity?

A public debate over containing health care costs has been brewing for a while; Perhaps, it has begun to boil over. On one side, the proponents of a public health insurance option clamor about the need to discipline private insurance companies. On the other side, insurance companies are clearly worried that a government option will be subsidized or supported in a way that cannot be matched privately. They logically worry that a public option might drive them under.

These are the central points in the current public debate, but I think they miss out an important aspect of health insurance markets: heterogeneity. This post tells a story that incorporates heterogeneity into the discussion on the consequences of a public option.

In what follows, I assume that private insurance companies survive the competition from a public option (and the public option and private insurance coexist). This might not actually be the form that health insurance takes, but it's a possibility worth considering.

Why does heterogeneity matter?
With regard to insurable risk, people vary drastically on how risky they are to insure. Private insurance companies are good at assessing risk, and crafting insurance policies to take that risk into account. Moreover, they have an incentive to make profit and no guarantee that they'll stick around if they make a series of mistakes that sends the company into huge amounts of debt.

That's a good incentive to monitor the risks the insurance company takes on. The profit motive (and little backdrop upon failure) means the insurance company works hard to contain its mistakes. Some people are costly to insure because they're unhealthy. Others are less costly to insure, and private insurance companies are happy to provide them insurance.

With regard to unhealthy people, it's not politically popular to raise premiums or limit coverage. Worse still, the government might not assess the risks well -- they are, after all, new to the business. This suggests that high risk individuals will be more attracted to the government option than low risk individuals.

As a result, unhealthy individuals flow to the public option; healthy individuals stay with their private option. If enough unhealthy people flow from private insurance to government insurance, the private insurance companies might even make higher profits. That's because their bad risks went to the public option.

In the extreme version of this story, the private insurance companies are left with only the low cost individuals, which might allow them to drop their premiums and make more profit. Suppose that happens for a couple years. Commentators will take that as evidence that the public plan worked to discipline private insurance companies. After all, the government entered and then the price dropped on most policies.

But, notice that my story has said nothing about discipline, and if you're following, you sense that there's a storm coming.

We started this story with the idea that the bad risks flow to the public plan. Who are these bad risks? They're people who are ticking time bombs, the heart attacks waiting to happen, people with a high likelihood of cancer, people who have pre-existing conditions, older people whose prescriptions are mounting, and so on.

We expect these individuals to cost a lot. The government might charge them more than good risks, but the government cannot summon the political will to charge these people what they truly cost the public insurance program. After all, public plan decisions will be made by a public entity with no intention of profit. Sure they want to balance their books, but they also want to garner votes for the politicians who gave them jobs.

Moreover, these high risk individuals might not cost a lot in the short term (2 to 4 to 8 years), but sooner or later the ticking time bombs will start going off. With each explosion, there's a corresponding explosion of costs. All of a sudden, the government plan's premiums won't cover the expenses.

Just like Fannie Mae and Freddie Mac, the public insurance option will have an implicit government guarantee. Worse still, by the time the costs get out of control, people will think that the public option is too central in the provision of health care to simply let fail. The end result: We're faced with a new series of bailouts and a bigger health insurance mess to clean up.

That's just one scenario; there are others. I hope that this sequence of events does not happen, but I'm not sure how to prevent it if we start down the public option road. Given the inevitable size of the problem, we need to weigh all of the potential consequences. I sincerely hope this story is fiction, but I worry that it is not.

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