By demanding that her health insurer pay her monthly birth control expenses, Sandra Fluke earned herself a speaking slot at the Democratic National Convention. Her speech, and several others at the DNC, insisted that every American should have basic health care. Most Republicans don’t disagree; they just believe there is a better way than Obamacare. The President’s reelection makes it clear that Obamacare will live on, but the debate over the federal role in health care will continue. Prospects for a bipartisan solution look grim, but it would surely help if both sides evidenced a better understanding of the purpose of insurance and the difference between health care and health insurance.
A government mandate for Fluke’s insurer to pay for her birth control pills really has nothing to do with insurance, in the traditional sense of that term. Either it would be a wealth transfer whereby others pay for Fluke’s pills with the insurance company functioning as the intermediary, or it would be a highly inefficient way for Fluke to pay for her own pills. Because the latter alternative would mean that Fluke would pay more for her pills through her insurer than she would buying them directly from the pharmacy, we can be pretty sure that getting someone else to pay, not insurance, is what this debate is really all about.
Proponents of Obamacare and defenders of Medicare “as we know it” will insist that those programs should be thought of as “social” insurance, and they will object to the term wealth transfer because, in modern political parlance, it implies that the goal is wealth redistribution, pure and simple. So let’s just say that Sandra Fluke wants free or subsidized birth control for herself and others. No matter what we call it, this cannot be accomplished without a wealth transfer, meaning that others will have to pay all or some of the cost. That might or might not be good public policy, but it is not insurance.
What Is Insurance?
What is insurance, and how does it work?
People face two kinds of future costs in their lives—those they can count on and budget for (or choose not to incur) and those that may or may not arise, depending on circumstances at least partly beyond each person’s control. We know we will have to pay for things like food, rent, transportation, movies, and booze. We cannot know ahead of time precisely how much those costs will be, but we know we will incur them and we generally have a good estimate of what they will be.
Other costs, like getting sick from food poisoning or being injured in an auto accident, are unpredictable both as to magnitude and frequency—they are risks, in other words. I can know with reasonable certainty what it will cost to take a vacation next summer. I cannot know whether I will incur the costs of an accident along the way, or what those costs will be if they do arise.
It makes sense for individuals to insure against the latter, unpredictable costs. It makes no sense to insure against the former costs, which, by the way, include birth control.
Faced with the risk of uncertain future costs, people can: 1) save, in advance, enough cash to cover future costs should they arise, 2) borrow in the event the costs are incurred, or 3) purchase insurance. Saving (we might call it self-insuring) is not a good option for most people because it ties up resources that could be employed for other purposes (opportunity costs), not to mention the impossibility of knowing how much to save and the high likelihood that the possible future costs will not be incurred, meaning the opportunity costs will have been needlessly borne. Borrowing after the costs are incurred is also not a good option for most people because they are unlikely to qualify for a loan, particularly after suffering a significant loss, and because, from that point forward (if they can get a loan), they will experience the opportunity costs of having to service their debt. For most people, insurance is the best alternative.
Consider the risk of a home-destroying fire. All homeowners face a small risk of incurring the large cost of having their home burn to the ground at some unknowable time in the future. Each homeowner could set aside enough money to cover the cost of replacing his home in the event of a fire. But most people could not afford to do so and those who could would bear the aforementioned opportunity costs. Alternatively each homeowner could take his chances of finding himself homeless in the unlikely event of a fire. Absent insurance, this is what most homeowners would do. But insurance makes it possible for homeowners to avoid, at relatively low cost, the prospect of being homeless after a fire.
It works like this: Let’s say 1,000 people own homes each worth $100,000. Assume we know from experience that the risk of a home-destroying fire in any given year is one in 1,000—i.e. there is a 100 percent probability that one of the 1,000 homes will experience a home-destroying fire each year and a 0.1 percent chance that any particular home will be destroyed in any given year. The cost to each homeowner to fully self-insure is $100,000. But $100,000 is enough to cover the risk faced by all 1,000 homeowners combined in any given year. If all 1,000 homeowners self-insure, they will set aside a total of $100 million to cover an annual expected cost of $100,000—or, to put it differently, enough to cover expected losses for the next 1,000 years. That would be crazy, which is why no one does it even if they can afford to do so.
What sensible people do is pool their 0.1 percent risk of a home-destroying fire through the purchase of insurance. An insurance company will happily guarantee to cover the future losses of all 1,000 homeowners at an annual cost to each homeowner of $100 plus some extra for expenses and profit—let’s say $150 per homeowner. That means the insurer will take in a total of $150,000 each year to cover an expected loss of $100,000. (Of course, insurers will need reserves in the event home fires in a particular year occur at a higher than expected rate, but that does not alter the basic point illustrated by the hypothetical example.)
Insurers need only three things to make this work for them: 1) reliable data on the likelihood and magnitude of the risk faced by each homeowner, 2) a large enough pool of insuring homeowners to assure that the annual payout will be reasonably close to aggregate projected losses based on those risk factors, and 3) premium payments sufficient to cover those projected losses plus expenses and profit. The larger the number of insured homeowners in the company’s pool, the more likely it is that the number and extent of actual losses will be close to the expected losses on which the premiums were based. The insurance company makes a profit, unless actual losses significantly exceed expected losses. Plus, at a tiny fraction of the cost of self-insuring, homeowners have the peace of mind of knowing that, in the unlikely event of a fire, their home will be replaced with one of equal value.
Meanwhile, homeowners face regular costs of ownership. Mortgage payments must be made, sidewalks shoveled, lawns mowed, light bulbs replaced, toilets plunged, dishwashers and garbage disposals replaced, and siding painted. We do not insure against these costs (unless they arise due to unexpected events) because they are virtually certain to occur and we can easily plan for them. Unless they are required to do so, insurers will not offer policies guaranteeing coverage of costs that are certain to occur at regular intervals for every homeowner because there would be no market for such insurance.
Consider another hypothetical example. Assume the average annual cost of light bulbs for each of 1,000 homes is $50. The expense for an insurer to pay for light bulbs for all 1,000 homes will be $50 per home or a total of $50,000. For this to be a viable business, the insurer will have to charge each homeowner enough to cover the expected payment of $50, the expenses of collecting premiums and processing claims and at least a small profit. Whatever one assumes about expenses and profits, the total charge to each homeowner will be more than the cost of the light bulbs. No one will purchase light bulb insurance if it costs more than maintaining a stock of light bulbs in the basement.
Confusing Health Care With Health Insurance
Health insurance works the same way, or at least it used to. Some people get cancer; others do not. Some people are seriously injured in accidents; others never have a serious accident. Like home fires, individuals cannot know in advance whether cancer or an accident will strike them. Insurance allows these low probability and often high cost risks to be pooled with each individual paying a modest premium in return for guaranteed health care in the event of serious illness or accident.
But insuring against routine health maintenance costs, like contraceptives, makes no more sense than insuring against routine home maintenance costs, like light bulb replacement. In both cases, we know in advance what the costs will be and that they will be incurred. Having the insurer pay only means we will have to pay more in premiums than the contraceptives or light bulbs would cost at the store.
If it doesn’t make sense to insure against routine costs incurred by all similarly situated individuals, why do we do it, or claim to do it, in health care? There are, no doubt, many explanations. Here are a few that seem obvious.
First, since World War II when the federal government forbade employers from competing for scarce labor on the basis of salaries and wages, employer-funded health benefits have been the norm. From the beginning these employer funded health plans did insure against the risks of serious illness or injury, but an important purpose was to substitute employer payment of insurance premiums and routine medical costs for the forbidden higher wages and salaries.
In effect, employers paid for both health insurance and health care. It worked for employers who could raise effective compensation (with significant tax advantages compared to cash compensation). It made sense for insurance companies, who got the insurance business and could collect fees for being the intermediary in the payment of routine health care costs. And it made sense for employees, who got effectively more compensation because they no longer had to pay for health insurance or health care.
Second, going way back to the beginnings of prepaid hospital and physician care in the 1930s, Blue Cross and Blue Shield were required by state enabling laws to use community rating in setting premiums (in return for tax exempt status and freedom from the cash reserves required of commercial insurers). Meanwhile commercial insurers price discriminated, on the basis of each insured’s personal health risks, in order to compete for business by holding down costs for lower risk customers.
Community rating (under which sick and healthy people pay the same premiums) works when employers are paying the premiums for workers who cannot opt to get their compensation in any other way, but not for commercial insurers with voluntary customers because many healthy individuals will choose to forego insurance rather than pay the necessarily higher premium. As more healthy people leave the insurance pool (adverse selection), the premiums for the less healthy will continue to rise until they cannot be afforded by anyone (except the government, or so we have pretended).
Third, the mid- to late-twentieth century quest for equality led some people to question and then challenge the practice of discriminatory pricing of insurance based on individual risk. Women of child-bearing age paid more for health insurance covering pregnancy and child-birth than did men of a similar age with otherwise comparable risks and coverage. People with other preexisting conditions that posed higher risks of future health costs were similarly charged higher premiums reflecting those higher risks. Equalizing premium payments across risk groups eliminated the perceived discrimination, but it did not change the aggregate projected costs for insurers. Their solution was to shift some of the costs of the higher risk pool to the lower risk pool in the form of higher premiums.
The result is that insurance for higher risk people is subsidized through higher than necessary premiums paid by lower risk people. Defenders of this movement toward community rating will point out that every insured pool includes higher and lower risk people, meaning that those of lower risk always subsidize those of higher risk. True, but as Obamacare’s individual mandate underscores, when risk differentiation is totally abandoned, the only way to keep the lower risk people in the pool in the face of rising premiums is to force them to purchase the insurance.
Obamacare is the latest development in this conflation of health care and health insurance costs. Community rating, coverage of children up to the age of 26 under parents’ policies, and mandatory coverage of contraceptives are all part of this trend. Insurers are less and less in the business of insuring individuals against unpredictable future costs and more and more in the business of collecting payments from some individuals to pay the routine medical costs of other individuals. There is little difference between this method of wealth redistribution and that which governments perform by collecting taxes from some to pay the health costs of others. We can call it “social” insurance, but it is not insurance in the traditional sense of risk based sharing of unpredictable future costs.
Our policy discussions will be more productive if we are clear about this fundamental difference between health insurance and health care. Health insurance provides an affordable way for people to meet unexpected health care costs when and if they arise. Private purchase of insurance at discriminatory (risk-based) prices in a competitive market gives individuals incentives to lower their health risks through better diet, exercise, and care, while insurers compete through lower prices and better service. Because of unavoidable transactions costs and necessary profits for insurers, insurance coverage of routine health care can only cause costs to rise. Thus, the only reason to do it is so that some get free or subsidized health care paid for by others. But recipients of subsidized or free health care have little or no economic incentive to lower their risks and thus reduce health care costs.
The better approach is to leave insurance to private insurers functioning in a competitive market and subsidized health care to the government and private charities. By separating health insurance from subsidized health care, it will be far easier to assure that only those in need are subsidized, thus preserving most of the incentive effects of having individuals pay for their own health care costs when they can afford to do so. Of course government can also subsidize health insurance for those unable to afford it.
Health insurance, properly understood, allows individuals to protect themselves, at reasonable expense, from unpredictable future health care costs. Insurer coverage of routine health care costs is simply an alternative to government subsidization of those costs for some people at the expense of others. Understanding the difference could help us to more effectively pursue policies that will: 1) allow health insurance prices to reflect only the cost of insuring against risk, 2) provide subsidized health care and health insurance only for those with demonstrated need, and 3) lead to lower health care and health insurance costs as a result of competition in both markets.
James Huffman is dean emeritus and formerly the Erskine Wood Sr. Professor of Law at Lewis and Clark Law School in Oregon. He served as dean of the law school from 1993 to 2006. Huffman serves on the boards of the National Crime Victims Law Institute, the Foundation for Research on Economics and the Environment, the Classroom Law Project, and the Rocky Mountain Mineral Law Foundation. He is a member and former chair of the Executive Committee of the Environment and Property Rights Practice Group of the Federalist Society. His research interests include natural resource, property, environmental, and constitutional law.