What Insurance Is

Paul Ryan, in defense of the new GOP healthcare bill, argued that Obamacare failed because it forced healthy people to pay for sick people, thereby resulting in a death spiral. Immediately, my twitter feed lit up with people mocking Ryan.

Karen Tumulty wrote “People who are healthy pay for people who are sick. Also known as “health insurance.”” Sarah Kliff, of Vox, wrote “Wait wait wait this is literally how insurance works.” Kliff was responding to Jonathan Cohn, who wrote “Paul Ryan says insurance can’t work if healthy must pay more to subsidize the sick. But this is exactly what happens in every employer plan.” [Sorry, I tried to embed the tweets themselves, but it didn’t work, and so I’m just doing the less technical thing. The citations are accurate.]

So there’s this idea out there. The problem is that it’s a really bad one. Cohn is actually making a better point than Kliff or Tumulty, but this line of argument is fundamentally misleading.

There is a sense in which insurance is a transfer of wealth from healthy people to sick people. If I buy an insurance plan on the open market, pay my premiums on time every month, but never go to the doctor (just because I’m young and healthy and don’t need to), then I’ve given away money and received nothing in return. The insurance company takes that money and uses it to pay the bills of some sick person. So that’s what insurance is: a transfer of money from healthy people to sick people.

But this is the wrong way to think about health INSURANCE. It’s actually not a bad way to think about health CARE. Healthcare is the healing of the sick, a practice which takes resources (time, energy, equipment, etc. etc.) To engage in the practice of healthcare is to dedicate those resources to sick people. Because otherwise those resources might have gone to healthy people, healthcare involves the transfer of resources from the healthy to the sick.

At a conceptual level, that’s just kind of obvious.

But if this is what health CARE is, then what is health INSURANCE? Health insurance is a financial product. You pay a certain amount to a company and they, in return, agree to pay for any medical expenses that might arise (in excess of your deductible, less co-pays, etc. etc. etc.).So when I said earlier that the young healthy person paying for insurance gets nothing, that’s wrong. They get a contract. They get coverage.

The essential point about insurance is that, even if you aren’t using health care at any given moment, that coverage is STILL a benefit. The benefit isn’t the obvious benefit that people think of it as – the benefit of health. Health insurance provides what economists call a CONSUMPTION SMOOTHING BENEFIT.

The idea is this. Let’s say that, as a matter of actuarial statistics, you can be reasonably certain that you will incur about $20,000 in medical expenses over the next ten years. The problem is that, for most people, that doesn’t mean that you need to pay $2,000 to the doctor every single year. It means you pay just a few hundred dollars most years, except for the one year when you have an emergency that ends up costing $15,000. How do you plan for that? How do you budget for it? One year there’s going to be an expense that eats up a huge portion of your income, but you don’t know what that year’s going to be. You’re not even sure if it will ever arrive: maybe you get lucky and have no medical emergencies any time soon.

Insurance is the solution to this benefit. If you’re going to pay $2,000 a year, on average, then why not just pay that much to the insurance company on a set of fixed monthly payments? That’s much better. Your life becomes much less stressful; your financial planning that much easier. You’re willing to pay a little something extra for that: so you actually pay the insurance company $2,100 per year. That regularity and predictability is worth $100 a year, you figure. And that $100 is what the insurance company uses to cover its overhead and make its profit. Everyone wins.

At least, that’s the story about how things would work in an ideal free market. The US health care system has never been an ideal free market, and it’s not likely to be one any time soon. But it’s important to understand the free market story because it helps understand what the BENEFIT of insurance is. The benefit of insurance is NOT HEALTH. It’s CONSUMPTION SMOOTHING.

HEALTH is something that people are willing to pay a lot of money for. Many medical decisions are literally life or death, and people are willing to put forward a lot of money to save their own lives. But CONSUMPTION SMOOTHING? I mean, that’s a nice thing to have. It’s certainly useful; I’d rather have smoothed consumption than unsmoothed consumption any day. I’d even be willing to pay a $100 per year premium to get my consumption smoothed. Perhaps more. Perhaps quite a bit more.

But if, as a matter of actuarial statistics, I should expect to pay $2,000 next year, on average, for healthcare, I won’t buy an insurance contract that asks me to pay $5,000 per year. I’m just not going to pay that much money for a consumption smoothing benefit. Maybe others have different preferences than I do, and they value a consumption smoothing benefit that highly. But, for the most part, you can’t charge someone  $5,000 per year for an insurance contract that is only worth a little more than $2,000 to them.

This is why the “insurance just is healthy people giving money to sick people” line is silly. Insurance is a financial product that provides a consumption-smoothing benefit. Consumption-smoothing benefits are substantial, but not THAT substantial, and people are unwilling to pay huge amounts to obtain those benefits.

What this all means is that, in an individual insurance market, A RATIONAL INDIVIDUAL WILL NOT BUY INSURANCE IF THE RATE IS SUBSTANTIALLY IN EXCESS OF THE ACTUARIAL VALUE OF THAT CONTRACT. THAT was Ryan’s point. And one of the provisions in Obamacare, “Community Rating,” requires that healthy people buy insurance at rates that are substantially in excess of the actuarial value of their insurance contract. This is why young people aren’t buying insurance. This is why the people covered by the exchanges are substantially sicker than anticipated. This is why so many people are worried about a “death spiral” in insurance markets. This is one of the biggest flaws in Obamacare.

And that’s why Ryan’s trying to fix it. I don’t think the GOP healthcare bill is any good. But Ryan’s at least identified a real problem that needs solving. This can’t just be ignored with “Doesn’t he understand what insurance is?” snark. Those making that argument are the ones who don’t seem to understand what insurance is.

At this point, I have to let Cohn off the hook, because the point that he’s making is both different and better than Kliff and Tumulty’s point. Cohn is pointing out that companies don’t buy individual insurance plans for each one of their employees. They buy a group insurance plan, which covers all of their employees. What this means is that an employer and an insurance company will set a price for the group insurance plan, where the value of that plan is determined by the average expected healthcare costs of the company as a whole. So with group contracts, there’s already quite a bit of money-pooling and risk-pooling going on, as the sicker employees of the company receive much more benefit from the group insurance contract than the healthier employees do. So Cohn is correct to say that group insurance contracts already have the kind of healthy-people-paying-for-sick-people that Ryan is criticizing.

But Cohn’s criticism of Ryan is still unfair. Group insurance has the kind of health-people-paying-for-sick-people structure that Ryan is criticizing, but that is a stable outcome in the group insurance market because of features that are particular to employer-provided group health insurance as it exists in the USA. For one thing, these benefits are massively subsidized. Second, and likely more important, employer-provided insurance is presented and thought of as a “benefit,” and its value is not closely interrogated. When employees are told about the size of the benefit package they receive, they receive a dollar number. That dollar number is, typically, a lie. It reflects the average per capita cost of the insurance contract that the employer is providing rather than the actuarial value of the insurance contract (plus consumption smoothing benefit) to the employee in question. Employer insurance is MUCH more generous to older, sicker employees than it is to its younger, healthier employees, and the system is held together by everyone vigorously pretending that this isn’t the case. Everyone is able to carry on pretending because employees are, for the most part, kept completely in the dark about the financial structure behind the benefits they’re receiving. (This isn’t a conspiracy; most people just don’t know or care about things like this, so they don’t bother to try to find out). In the individual market, things are much more transparent. The artifice doesn’t work.

Health CARE is incredibly important. We’re willing to pay quite a lot for it. Health INSURANCE is not. It provides a benefit to your ability to successfully manage your finances, which is useful, but not in a life-or-death kind of way. It’s a mistake to conflate the two, and one of the biggest problems with conflating them is that you start to treat health insurace as being much more important than it is. You can’t charge people too much for their health insurance, or else they’ll just change to buying healthcare directly.


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