Health-Status Insurance: How Markets Can Provide Health Security
by John H. Cochrane
Executive Summary
None of us has health insurance, really. If you develop a long-term condition such as heart disease or cancer, and if you then lose your job or are divorced, you can lose health insurance. You now have a pre-existing condition. Insurance will be enormously expensive if it’s available at all.
Free markets can provide long-term, portable, health security, allowing consumers great freedom of choice, and allowing unfettered competition to deliver us all better medical care at lower cost. “Heath-status insurance” is the key to letting this happen. In a competitive market, sick people who are likely to cost more in the future must pay higher medical-insurance premiums than healthy people. Then, anyone can get medical insurance, albeit at a price. Health-status insurance pays a lump sum, when medical premiums increase, sufficient to cover the higher premiums. It covers the risk of premium reclassification, as medical insurance covers the risk of medical expenses. With health-status insurance, you can always get medical insurance, no matter how sick you get, at no change in out-of-pocket cost, and you are always free to change jobs, move, or change medical insurers.
Most regulations and policy proposals aimed at improving long-term insurance limit competition and consumer freedom, by banning risk-based pricing, forcing insurers to take all comers, strengthening employer-based or other insurance pools, or introducing national health insurance. To let health-status insurance emerge, we must instead remove the legal and regulatory pressure for employer-based group insurance over individual insurance, and then remove regulations limiting risk-based pricing and competition among health insurance.
John H. Cochrane is the Myron S. Scholes Professor of Finance at the University of Chicago Booth School of Business and a Research Associate at the NBER. He thanks Joe Feldman, Mark Pauly, and especially Michael Cannon for helpful comments.
Health-Status Insurance: How Markets Can Provide Health Security
by John H. Cochrane
The Problem of Long-Term Insurance
None of us has health insurance, really. Most Americans have coverage through their employer, or the employer of a parent or spouse. But you can lose that health insurance if you get cancer, heart disease, HIV, have a stroke, discover a genetic defect, or develop any other long-term expensive health problem; and if you then lose your job, are divorced, or outgrow your parents’ plan, or if your employer goes out of business. 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 United States. Many other people stick with bad jobs or bad marriages just to keep their insurance.
The lack of secure, long-term, portable health insurance is the greatest single problem with our current health-care system. Solving this problem is an announced goal of every health-care reform proposal from all parts of the political spectrum. There are plenty of other problems and pathologies with our health sector: the uninsured, hospitals’ hotel-minibar pricing policies, poor information, the drudgery of useless paperwork, cost recovery of new medicines, the optimal amount of copayment, and so on. But all of these are fairly clear problems, each limited in its reach, with fairly clear remedies. The lack of long-term insurance, by contrast, seems a harder nut to crack. And unlike, say, the plight of the uninsured, it is a problem that faces each of us directly.
Our current health-care system already includes an extensive array of laws and regulations designed to foster long-run insurance. Most proposals to improve long-run insurance add to these regulations. These regulations and proposals stifle competition and individual choice, by design. Their logic leads inevitably and inexorably to national health insurance. On the other hand, calls for greater competition in the health sector point rightly to the efficiency, innovation, and freedom it can bring, but by and large must admit to weakening long-term insurance. We seem to be stuck with a never-ending tussle between long-term insurance on one side and competition, market discipline and individual freedom on the other.
This unpleasant dilemma is not inevitable. We can have both completely portable, liftetime health insurance and a completely deregulated, competitive, efficient and innovative market that allows great individual freedom. Health status insurance is the key innovation that avoids the dilemma.
Health-Status Insurance
Market-based lifetime health insurance has two components.[1] First, medical insurers must be allowed to charge sick people higher premiums, and to charge healthy people lower premiums. Insurance companies refuse coverage, deny preexisting conditions, or more subtly avoid or mistreat sick people only because they can’t charge sick people enough to cover their costs. If insurers can charge enough, they’ll compete for everyone’s business. More subtly, if everyone pays the same premium, another insurer can woo the healthy away, leaving the original insurer with only expensive sick customers.
Second, we need “health-status insurance,” so that people can pay higher premiums. If you get a long-term condition that moves you into a more expensive medical-insurance premium category, the health-status insurer pays you a lump sum large enough to pay your higher medical-insurance premiums, for the rest of your life, with no change in out-of-pocket expense.
You can also think of health-status insurance as insurance against the risk that your medical-insurance premiums rise. Health poses two risks, really: the risk that you will require treatment during the coming year, and the risk that you will develop a condition that raises your medical-insurance premiums. Medical insurance covers the first risk, but we are poorly insured for the latter risk. Health-status insurance fills that gap.
Health-status insurance solves the central problem with our current health-insurance market: the lack of real, long-term, portable health security. With health-status insurance you have health security for life, no matter how sick you get, and whether you change or lose jobs, move, divorce, or take some time out of the labor force, or even let medical insurance lapse. You will always have the resources to purchase medical insurance. It is a completely market-based system, needing no regulation.
Health-status insurance will also give each of us much greater freedom and choice. No matter how sick you get, you will always be completely free to change medical insurers. You can always afford the higher premiums a new insurer will demand, just as you can afford the higher premiums your current insurer will require. You will not depend on the good treatment of one insurer or the vagaries of one group, the link to one employer, or the bureaucratic decisions of one government-provided plan, no matter how sick you become.
Freedom for consumers and deregulation of the market will force much greater competition among medical insurers and medical-care providers. Medical-insurance companies will compete for the business of sick, expensive, high-premium customers, rather than try to get rid of them or “contain their costs.” Medical-insurance companies can be allowed to freely compete for healthy people too, offering them better service or lower premiums, since we no longer need to keep the healthy around to subsidize the expenses of sick people in their group. Constant competition for every consumer will have the same dramatic effects on cost, quality, innovation, and variety of service in health care as it does in every other industry.
Obviously, the policy steps needed to bring about health-status insurance go in the opposite direction of most current regulation and policy proposals aimed at strengthening long-term insurance, which feature less risk rating, less competition among insurers, and forcing employer-based group coverage or national health insurance. I discuss the policy process in some detail below, after a closer examination of health-status insurance.
Health- status accounts
The lump-sum payments from health-status insurers should go into a special “health-status insurance account” that can only be used to pay medical-insurance premiums or medical expenses. This requirement is part of the contract, not a regulation. It solves the obvious problems of contracts that pay large lump sums, and it makes health-status insurance less expensive, for three reasons. First, 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. Second, this provision makes it feasible to require that you return the lump sum if you become unexpectedly healthier, and your medical insurance premiums decline. In this circumstance, you no longer need the lump sum, so promising its return does not hurt you. By lowering costs, returning the unneeded lump sum lowers premiums. Of course, if your health status deteriorates again, you will receive another lump sum. 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.
Health-status insurance accounts are not the same as health savings accounts. Health savings accounts are tax-preferred savings vehicles. You choose when to put money in, and you are allowed to withdraw money for non-medical purposes and to pass the assets on to heirs, as well as to pay for medical expenses. Health-status insurance accounts are funded by health-contingent payments from an insurance company, they are set up like a trust account to fund specific payments, and they are not inheritable and cannot be used for any other purpose.
However, health savings accounts are a great first step, as they establish a legal and regulatory framework for accounts that are limited in some ways to health-related uses. Now, markets need only create a variant of something that exists, rather than something totally new.
An Illustration
Suppose that a healthy 25 year-old male will incur $2,000 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 one-percent chance of developing a chronic condition that will raise his average medical expenses to $10,000 per year. 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 is a large financial setback.
To be covered over the long term, then, he needs a lump-sum payment large enough to cover $8,000 per year in additional medical-insurance premiums. At a five-percent interest rate, that sum is[2] $148,370. A fair premium for health-status insurance is one percent of that value per year, $1,483.70, plus administrative costs and profit.
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 of the sum of medical- and health-status insurance premiums.[3] 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 pays $2,300 at 25 rising to $10,023 at age 55. Clearly, jumping from the low-risk to the high-risk category implies a large financial penalty. They estimate that the combined medical- and health-status premium starts at $1,487 at age 25 and rises to $3,936 at age 55. Subtracting, health-status premiums are $687 at age 25, rising to $898 at age 55. Total premiums for younger enrollees are still lower than for older enrollees, unlike in my example. That fact reassures us that young healthy people, who typically have lower incomes than later in life, will not shy away from purchasing insurance even though the premiums are front-loaded.
Details, Elaboration, and Objections
Interruptions
Health-status insurance has another advantage over most other approaches: it can provide long-term security through interruptions or changes in medical insurance. With employment-based or long-term individual coverage, as soon as you stop making premium payments, you lose any right to low premiums and to continued coverage of your (now preexisting) medical conditions: You lose long-term insurance.
This happens. 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 portion. But this privilege doesn’t last forever, and people who just lost their jobs often have trouble paying premiums, especially if the job loss coincides with an expensive illness.[4] And people who take time off from work to raise a family, or lose their connection to health insurance through divorce, don’t have any right to continue coverage in the first place. They are in even worse positions.
By contrast, anyone with a health-status account can switch to a lower-cost medical plan, or miss some period of medical coverage entirely in order to adapt to economic misfortune, and retain protection against the costs of long-term illnesses. When they’re ready to reestablish medical insurance, or move back to a more expensive medical-insurance plan, the health-status account is there and waiting.
Similarly, the health-insurance account protects people against the risk that their employer goes out of business, is taken over, or simply decides that paying decades worth of health expenses is too costly.
Premium Categories, Contract Simplicity and Contracting Costs
Calculating present values of premiums sounds complicated in the real world. However, in the real world we don’t insure people down to the last dollar, so it is not necessary to key health-status payments precisely to the exact present value of each person’s premium for a given plan’s premium 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.