Out of Death Spiral, Into the Fire

by Chidem Kurdas

A big rate hike by an insurance company in California’s market for individually purchased health insurance provided a rationale for the new Obama care proposal. As Paul Krugman explains, the key issue is adverse selection: people who retain coverage tend to be those with high medical expenses.

Those with low expenses tend to drop out in hard times. That increases costs, causing premiums to rise, so even more  people drop out—an insurance death spiral.

The solution proposed in the administration bill – as in previous Congressional bills – is to make insurance mandatory.  With healthy people in the pool to share the costs, presumably premiums can be kept down. But even passionate proponents of compulsory insurance don’t really believe this,  so the President  proposes a new federal agency, the Health Insurance Rate Authority, to control price increases.

At this week’s NYU Market Institutions and Economic Processes colloquium, Gene Callahan made a comment that’s the best descriptor I’ve heard for the health insurance situation, though he was speaking of another topic: “However bad our current situation may seem, there is always some reform available that could make it even worse.”

Gene’s adage should be emblazoned on the walls of the room where the President’s health summit will take place this Thursday.

Let’s start with the possibility that the Health Insurance Rate Authority keeps a lid on insurance premiums while the cost of medical services continues to rise faster than inflation and people use more services, as has been the case for decades. Insurance companies will have to either reduce the services they cover– but regulators and courts will hinder that – or go out of business.

The likely process is a different sort of death spiral: as private insurers go out of business, the government will take their place. Obama et al don’t want to admit this is the logical end point of the so-called “reform” because it is not popular, but it’s not a bad outcome if you like big and even bigger government.

We have a sort of preview of this scenario. According to recent government estimates, US health care spending reached $2.5 trillion in 2009. Was this because of private insurance? No, it was because of a huge burst in Medicaid spending. According to the report in Health Affairs, spending by public payers grew  much faster (8.7%, to $1.2 trillion) than spending by private payers (3% percent, to $1.3 trillion).

This happened mainly because more people enrolled in Medicaid while private insurance shrank—a microcosm of the process that the Obama proposal will set into motion. Total spending on healthcare grew 5.7% since 2008 even as GDP declined. What it shows is that  state and federal agencies can’t control the medical costs they pay for.

What will they do if they became the only payers? Judging from the past, they will raise taxes. We’re looking at substantial growth in the $1.2 trillion public healthcare tab. The particular taxes in the new bill – such as penalties on businesses that don’t offer coverage and individuals who don’t carry insurance – are unfair but comically inadequate in terms of revenue that can be raised.

But suppose the proposed Health Insurance Rate Authority is captured by insurance companies – as happened to utility regulators – and rubber stamps the rate increases insurers want. Insurance companies will then survive in symbiosis with the government. Prices won’t be any lower, our choices won’t be any better and there will be yet another bureaucracy to brighten our existence.

The way to tackle the adverse selection problem is to equalize the tax treatment of employer-mediated vs. individually purchased insurance. A proper tax credit for the latter would bring a lot of people back into insurance pools.

28 thoughts on “Out of Death Spiral, Into the Fire

  1. A friend of mine at the GMU law school calls the idea behind Gene’s statement: The Weimar Fallacy. Nothing could be worse than the Weimar Republic in Germany. Right.

  2. Are the NYU colloquiums open to the public? I’ve been wanting to attend for a while, but I’m not really affiliated with NYU’s econ department (though, I could actually stretch my official affiliation status with the universities larger network if need be).

  3. The Weimar fallacy is fantastic. 🙂

    I didn’t know about the tax advantage of employment-based health insurance. How much is it in relative terms?

    O.T. I just read Andreas Hoffman’s paper on the overconsumption cycle in Eastern Europe: it is very interesting. Was it a working paper or has it been already published somewhere?

  4. To deal with adverse selection, you also need to eliminate mandated benefits and community rating.

    Adverse selection is usually said to be a problem of asymmetrical information; if the insurer can’t distinguish between people of different risks, it has to charge them the same premium. But that’s not true in the case of health insurance. Why would the healthy opt out if they could instead just pay lower premiums commensurate with their risk? Because mandated benefits drive up the minimum, and community rating (where required) forces everyone to pay the same.

  5. Obama’s proposal to federally control prices of health insurance has made big headlines, but there seems to be little appreciation for how much price control there is already in certain types of insurance in the US. Most types of property & casualty insurance (homeowners, auto insurance, workers’ compensation, etc.) are heavily regulated at the state level, including price controls. There are different types of price regulation depending on the state, including “prior approval” (you must get permission from the state to change what you charge); “file and use” (you must file with the state but don’t need permission before you change what you charge); etc.

    It’s more under-the-radar than federal regulation of health insurance would be, but there have been some spectacular problems in local markets, especially when the issue gets politicized – think New Jersey auto insurance a few years back or Florida homeowners insurance.

  6. Glen brings up the problems of mandated benefits and community rating. There is also the problem of guaranteed issue. Some states have prohibited deductibles beyond a certain low limit, which prevents insurers from offering high deductible, low premium policies, which would be more affordable. This clashes with the first dollar payout model, which has long been advocated by the Blues (John Goodman wrote a good essay on the history of the Blues, which is archived at the econlibrary) and various “progressive” reformers. It’s fundamentally opposed to one of the cardinal principles of insurance, namely that an insured should have some “skin in the game,” financially speaking, which leads to more circumspect (read: healthier) behavior, fewer claims, and lower costs for both insureds and insurers.

  7. Gary, that’s a very good point. States’ regulation of insurance would make for an interesting comparison. And as someone who once lived in NJ and experienced the auto insurance nightmare there, I can personally attest to the horrors of politically controlled insurance schemes.

  8. I like the term “Weimar fallacy” The same type of state of mind could also be called the 1914 fallacy– the war was supposed to cure all that ailed people. “The war seemed like a magic holiday,” says Amos Elon in The Pity of It All.

  9. Pietro, the value of employer-sponsored insurance is tax exempt; it is excluded from the employee’s taxable income. For the employer, it is a deductible business cost. But when you buy the same insurance as an individual, the money you spend is subject to the federal income tax like the rest of your income. Some estimates of the employer health insurance tax subsidy can be found at

  10. Glen, I agree with you about mandated benefits. One reason why buying individual insurance in NY is prohibitive is that the state legislature has piled up mandates for any policy sold in the state–like a requirement that lavish treatment be provided for substance abuse. As a result, many insurance companies that operate in neighboring states won’t even sell individual policies in NY.

  11. Bill, I agree. It makes a lot of sense for beneficiaries to take on some costs so that they’ll act responsibly. State governments have a lot to answer for in the health insurance problem.

    My point is that on the federal level, an across-the-board refundable tax credit – as some members of Congress are proposing – is the right way to get people to buy insurance. This is the better alternative to making insurance mandatory and then subsidizing some groups at the expense of others–which is what the current bills do.

  12. chidemkurdas, wouldn’t the ability to buy across state lines be a better way to keep prices in check? I hear you can get a decent if somewhat barebones policy in Nevada
    for a very low premium. Why shouldn’t a resident of the People’s Republic of [fill in the blank} be able to buy one?
    A couple years ago I was in a health food store in lower Manhattan and got talking with a fellow, who turned out to be a psychiatrist at a local hospital or medical facility. I don’t recall how the conversation drifted to that. As a certified Szaszian, I told him of my libertarian and Szaszian views, and he replied something to the effect that I was an ignorant fool. Always a possiblity of course, just as it’s a possibility that he’s a rent seeking therapeutic state fan.
    If I had my druthers, you could buy insurance a la carte, paying a very high deductible and correspondingly low premium only for those benefits you want to pay for. No “mental health”/shrink benes if you don’t think you’ll ever be a nut case in need of a shrink, etc. I’ve heard that certain lobbies are really strong here in the People’s Republic of New York, especially the “mental health” lobby, and that they’ve had a strong hand in driving up insurance prices thanks to mandated “benefits.”

  13. Dear Pietro,

    thanks for your interest in the paper.
    It has not been published yet. I submitted it. Still working on it and changing things for a final version.


  14. Andreas Hoffman: best wishes for the reviews!

    Chidemkurdas: thanks for the answer. A 40% subsidy per family seems a lot of money, no mystery it is much distortive. It also means that 40% of the costs of health insurance of other types goes in taxes…

  15. Bill Stepp, you won’t get any argument from me. Yes, I’d love to be able to buy a basic policy in Nevada, but even if it were legal to go across state lines, the fact that NY mandates substance abuse coverage for its residents while Nevada does not would just about guarantee that the Nevada insurer would not sell to NY residents. So, getting the right to cross state lines would be a fine start but it does not solve the state mandates problem. You have to get rid of the mandates–a great idea, but as you very astutely point out, there are powerful vested interests behind these things and that’s why they exist.

  16. By the way, a tax credit that equalizes individual purchases of insurance with employer-sponsored insurance does not in any way prevent other measures– such as tackling mandates and opening up the insurance market across state lines.

  17. chidemkurdas,
    I assume the People’s Republic of NY mandate you mention could be circumvented by buying a policy outside the PRNY, like one supplied by an insurer in Nevada. Wouldn’t a PRNY-mandated mandate (ugh) apply only to insurers operating offices (or having agents) inside the PRNY? IOW, buyers of insurance could get around mandates in their home PRs by doing an end run geographically. And people in the PRCA could buy a Nevada-issued policy, etc.

  18. Bill Stepp, It depends on how a new law is written. The way you specify it, yes indeed the mandates could be circumvented. That would be very nice.

    But if the rule says any insurer selling to a resident of a mandate-ridden state has to meet the mandates, then there is no circumventing. It is a fair guess that the interests you’ve mentioned will lobby all out to keep the mandates even if a cross-state market can be created.

  19. Obama’s latest Proposal:
    • Requires U.S. citizens and legal residents to have qualifying health coverage
    • Individuals without qualifying coverage could face a penalty up to 2.5% of income
    (from http://online.wsj.com)
    The word “qualifying” is key–they can pile the mandates for coverage to qualify.

    The tax credit they’re willing to give comes with an income test: no more than $88,000 for a family of four, or 22,000 per person. That will not solve the problem of getting enough people into insurance pools– because many will be above that income. Employer-sponsored insurance, by contrast, has no income test.

  20. Insurance Reform Junkies,
    I believe that lowering taxed would stimulate the economy to a far greater degree than any stimulation package that Obama has tried and do it on a much quicker pace. Likewise, (if logic would have it) if Blue Cross lowered rates or ran specials would that not attract these younger folks back to obtaining coverage? One would think that Obama Care is designed to make private insurance obsolete. Why would the insurance companies not at least try this approach? Mind you, I am no insurance specialist but…if it works for taxes, why not insurance premiums???

  21. You guys should be cautious with these anti-government statements. You never know what law they pass next! 🙂

  22. Jim, To cut rates, a private insurer has to also cut costs. If they can pay less to service providers and/or cover fewer services, that would work. Otherwise the company will sooner or later go out of business. State mandates, legal challenges and political reaction makes significant cost cutting almost impossible. But you are right that insurers take the easy way out and raise premiums every chance they get. What’s needed is a competitive open market that gives individuals greater choice. That’s what going across states would help achieve.

  23. Chide…,
    We are all cutting costs right now. The national homebuilding company I worked for did, they cut me. I may be ignorant to the workings of private insurance companies but I have to think that they will have to at some point start cutting the cost side of the Income and Expense statement rather than just increasing revenues. We had to lower home prices to continue selling. I still don’t see the difference. I know that if Blue Cross put a similar policy out there that I was finally approved under by CIGNA that I would go to Blue Cross. Across State lines…yes, all the better, but they better not wait to start getting competitive to make this service affordable or they will become the next bubble to pop, then Obama will surely take over the industry through bail outs. No?

  24. Andreas,
    I see a majority of the problem being not enough people step up and communicate the realities of today’s government. If they pass a law and come and carry me away and take my freedom for standing up for what I believe think or know to be either a better way or at least know I don’t want to go a particular direction…so be it. The liberties we loose out of fear of the government will surely drop the American people to their knees. When government fears the people this insures a free people.

  25. Jim, I see your point and certainly do not want to defend insurance companies. But there is the issue that in states like NY or California, you can’t buy basic, low-cost health insurance because state governments have decreed that all policies have to cover this, that and the other thing. Moreover, the new federal government proposals add other mandates. It would be possible to buy cheaper coverage if one could pick what one wants and shop among insurers nationally. Instead of mandating what you have to get, governments should do their job by making sure insurance companies cover whatever they’ve agreed to cover when they sell the policy. There is a ton of regulation that makes insurance more expensive but does not protect you when an insurance company plays games.

  26. “Health insurance rate agency”? Does lil’ Obama not understand that you cant just make all things perfect by legislating they be so?

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