TCS Daily

You Call This Health Insurance?

By Arnold Kling - September 28, 2004 12:00 AM

"Even though most health care and most health insurance were provided privately, the U.S. health care system developed into a regulated, institutionalized market, dominated by nonprofit bureaucracies. Such a market is very different from a truly competitive market. Indeed, the primary reason that the medical community created the Blues was to avoid the consequences of a competitive market -- including vigorous price competition and careful oversight of provider behavior by third-party payers."
-- John C. Goodman, Health Insurance, from the Concise Encyclopedia of Economics

One of the most serious impediments to rational debate on health care is the misuse of the term "health insurance." What we call health "insurance" in this country was never designed to insure the consumer. Instead, its purpose is to insure steady, reliable incomes for health care providers. True health insurance is the economist's equivalent of a unicorn -- we can describe it, but none of us has actually seen it.

Split the Check

What Blue Cross and Blue Shield pioneered was a "split-the-check" approach to health care. An equivalent plan for restaurant meals would be that instead of paying for your meal, you would pay an annual premium to "Blue Eats," which would in turn reimburse restaurants for their costs, plus a profit margin. Every individual member of "Blue Eats" would have an incentive to eat out a lot and order the most expensive items on the menu, because the cost is shared among all of the members of "Blue Eats."

"Blue Eats" would be a great marketing ploy by restaurants, because it would get people to eat out more and spend more at restaurants. Similarly, John C. Goodman argues that what we call "health insurance" originated as a marketing ploy by physicians and hospitals. It worked really well, too.

Pass the Buck

Joan, a friend of mine who teaches in the Prince George's County, Maryland public schools, was bragging to me about her health care plan. Evidently, one of the options that she has is to pay a small fee -- I believe she said $15 a year -- to obtain coverage for eyeglass prescriptions. This coverage allows each person in her family to obtain new eyeglasses once a year at relatively little cost.

If you were to ask Joan where the money comes from to pay for her eyeglasses, she would answer "The insurance company," as if the company that administers the benefit program is some sort of Fairy Godmother handing out checks. In reality, the money for Joan's family's eyeglasses comes from one or more of the following sources:

  • Other school system employees, whose wages are reduced in order to help subsidize Joan

  • Students in Prince George's County, for whom fewer resources are available

  • The taxpayers of Prince George's County. They are subsidizing Joan, who lives in a wealthier county and who can afford to send two of her children to expensive private colleges and a third to a private high school in the area

Joan is not splitting the check. She is passing the buck. Someone else is bearing the cost, which makes Joan a winner.

Still, pass-the-buck is like split-the-check in that Joan is not the biggest beneficiary of the eyeglass coverage in her health plan. She is not the one who would fight tooth and nail if an attempt were made to curtail coverage. The big winners are the eyeglass shops in the area, who enjoy increased demand for their products and services. The coverage that pleasantly surprises Joan ultimately represents a marketing ploy on the part of the eyeglass industry.

What is Insurable?

One of the most important things to understand about insurance is that it is necessarily related to the concept of risk. A pool of people get together and share the risk of a rare event that affects one person at a time.

Insurance is only possible when the event that triggers a claim is highly improbable. The more likely the event is to occur, the less insurable it becomes. The table below indicates medical expenses that are insurable (because they are improbable or uncommon) vs. uninsurable.


Insurable (Uncommon)

Uninsurable Event (Common)

Cancer or heart disease

in someone under 45

in someone over 55

Expenses for major illness

new diagnosis

pre-existing condition

Prenatal and postnatal care

for an at-risk or genetically deformed infant

for a healthy infant

Lots of routine medical expenses (prescription drugs, doctor visits, etc.)

for someone under 50

for someone over 60

Medical expenses after retirement

after age 90

between ages 65 and 80

Long-term nursing care

for someone aged 60

for someone aged 80

Events in the right-hand column can be covered by third-party payments, and you can call that "insurance," but it isn't. It is some variation on "split the check" or "pass the buck."

For example, an insurance company's coverage of prenatal and postnatal care for a healthy, normal infant is at best a "split the check" system among a pool of young families, and at worst a "pass the buck" system that takes from the non-child-bearing and gives to the child-bearing. If it is a pool of young families all having children, then what the insurance company gives in benefits it will take away in premiums. Nobody is any better off.

On the other hand, insurance coverage of the relatively rare event of a deformed infant makes a real difference in people's lives. The unlucky family gets its expenses covered, while the lucky families have paid premiums and not received any payments. That is true insurance.

Medicare is primarily a "pass the buck" program. Those between the ages of 65 and 80, with predictably high medical expenses, are covered by the taxes on the working population. It is really only possible to provide insurance for those who live past 90, because it is unusual to live that long (although it is getting to be less unusual as health and medical care improve).

Note that I am not saying that pre-existing conditions per se are common. However, it is common for a pre-existing condition to lead to large medical expenses, which is what makes pre-existing conditions uninsurable.

Long-term Care Insurance

To understand the point about insurable vs. uninsurable events, consider long-term care insurance. This insurance provides for personal care for someone who becomes incapacitated. As this Consumer Law Page article indicates, the premiums for long-term care insurance are much more affordable the younger you are. As you get older, the premiums rise, and people often cancel their policies.

Does the fact that people buy long-term care insurance when they are, say, 55, and cancel the policies when they are, say, 75, mean that the long-term care insurance is a scam? Not according to the economics of insurance (it may be a scam for some other reason, such as fraud).

It is true that you are more likely to need long-term care when you are past 75. However, you are more likely to need long-term care insurance when you are 55. Remember, insurance only works when something occurs rarely. It is rare for someone aged 55 to need to go into a nursing home. It is not nearly so rare for someone over 75 to need to go into a nursing home.

To deal with the prospect of requiring long-term care after the age of 75, the only choice you have is to save up for it. If we do not save for our own long-term health care, then someone else will have to pay for it. We cannot insure against it, because it is too close to a sure thing. The reason people tend to cancel their long-term care policies as they get older is that the actuarily fair premiums are so high that at some point it just makes more sense to save up for the inevitable long-term care rather than to buy "insurance."

From an insurance standpoint, it may make sense to buy long-term care insurance when you are 55 and to renew your policy for five or ten years, to guard against the risk that you will be one of the unlucky people who becomes incapacitated relatively early. However, in addition to the insurance, you still have to set aside savings for the more likely scenario, which is that you remain non-institutionalized through age 75 but require long-term care some time after that.

For insurance to work, your expenses have to be unpredictable, so that you contribute to the insurance fund most of the time. With predictable expenses, you would always be drawing from the insurance fund and never contributing to it, so that insurance is not possible. The only way to pay for predictable medical expenses is out of savings.

Insurance is possible when there are unpredictable expenses, not when there are predictable expenses. Again, there are plenty of ways that our society can arrange for other people to pay for your predictable expenses, but those arrangements are "split the check" or "pass the buck." They are not insurance.

(CORRECTION Sept. 29: A reader forwarded me this link: NAIC shoppers guide. Contrary to what my article originally suggested, many long-term care policies have premiums that do *not* increase with age. In my view, this makes it more likely that a consumer will be able to afford the premiums as the consumer gets older, and it makes more sense to hang onto such a policy. On the other hand, this makes the premiums more expensive than they would be on policies that work more like "term" insurance, where the premiums adjust with age. The true cost of long-term care insurance does rise with age. If your premiums do not rise over time, that means that the higher cost is built in to premiums at the front end. -- AK)

What Economists Call Health Insurance

The unicorn that economists would call health insurance would focus on insurable events. Each type of event might be covered by different forms of insurance.

Being first diagnosed with an expensive disease would be an insurable event. It would trigger a large payment, but that payment would not be reimbursement for expenses incurred. Instead, it would be a share (preferably a large share) of the entire expected lifetime costs associated with that disease.

Reaching the age of 65 would not be an insurable event, so that Medicare would not kick in at that age. Instead, reaching age 80 or 85 might be the insurable event. For your own predictable medical expenses in the 65-80 age range, instead of a system that taxes the young to pay for the old, during your working life you would save up for those expenses. The transition from the current system to my proposed system would be gradual (see Phase Out Medicare).

Giving birth to an at-risk or deformed infant would be an insurable event. Perhaps all pregnant mothers would automatically sign up for insurance, creating a pool of premiums to fund the reimbursement of the unlucky families.

Becoming incapacitated at a young age would be an insurable event. Young people should be encouraged to purchase disability insurance.

What People Want

What economists consider real health insurance is different from what people want. Doctors and other medical suppliers want the old Blue Cross/Blue Shield type plans, which help boost supplier incomes. Young people want to avoid paying premiums for insurance, but still get bailed out when they get hit with bad luck. The AARP wants to lock today's working population into the existing Medicare system, which is a prescription for a train wreck. Everybody wants a Fairy Godmother to pay their health care expenses for them, but no one wants to be the one that ends up having to pay for the Fairy Godmother.

In the political market place, it will pay to promise people what they want. As an economist, I have the unfortunate duty of explaining that what people want is not what they can have. Should they reach that level of understanding, they may begin to appreciate the merits of true health insurance.


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