If you’re not an economist, that statement may not strike you as especially odd. After all that’s what you would likely hear in just about any garden variety history class. Or sociology class. Or political science class. But then again, most historians, sociologists and political scientists have never mastered even rudimentary economics.

To understand economic regulation one must turn first to people with a bit more knowledge. Interestingly, the father of economics, Adam Smith, devoted a good bit of his treatise, An Inquiry into the Nature and Cause of the Wealth of Nations, to the subject of regulation of economic activity. Smith observed that the vast majority of government regulations serve no useful social purpose at all.

Far from protecting consumers, most government intervention in Smith’s day was designed to protect producers and other special interests. They served the interests not of buyers of goods and services, but of the sellers. Further, society would be much better off if these laws were simply repealed.

What about the modern era? It’s amazing how little things have changed.

Hollywood depicts the downside of regulation.

As Gabriel Kolko (one of the few historians who did understand regulatory economics) wrote in The Triumph of Conservatism, every major regulatory agency established in the Progressive era was established at the request of the regulated industry. There were consumer complaints of course. But the design and thrust of regulation primarily served the interests of the producers, not the consumers. This was also generally true of the whole slew of regulatory agencies created during the New Deal.

The first meat inspection law was designed to squelch competition and serve the interests of the large meat packers. The Interstate Commerce Commission mainly served as a cartel agent for the railroads and had the primary goal of making the railroads profitable. Trucking regulation was designed for the benefit of truckers. Airline regulation for the benefit of airlines. Agriculture regulation for the benefit of farmers. Franklin Roosevelt’s National Industrial Recovery Act allowed producers in every industry to set up a cartel backed by the force of law, until it was mercifully declared unconstitutional by the Supreme Court.

At the state and local level, one out of every three jobs now requires a license. Yet for the most part, regulation of the professions appears little different from the medieval guild system that Adam Smith criticized more than 200 years ago. As Milton Friedman pointed out in Capitalism and Freedom, there seems to be no legitimate justification for any of this. Perhaps there is a role for government as a certifier, but not generally as a regulator. Let the government inform you that I have no skills at barbering. But having done that, there seems to be no good reason to prohibit me from putting a bowl over your head and clipping around the rim.

While promoting a naïve “public good” explanation for regulation, Reinhardt acknowledges that there are special interest pressures. But he treats these as distractions, when in fact they are the main event. Virtually all interests are special interests, including consumers. There are no general interest lobbies. There are no general interest PACs. There is no organized group pushing for what economists call Pareto optimality. So why would you be surprised to learn that we don’t have it?

Health care, by the way is no exception to the general rule. As I pointed out years ago in Regulation of Medical Care, most regulation of medical care is pernicious. Almost none of it is designed to protect the patient and it makes costs higher, quality lower and access more difficult than would otherwise have been the case.

Here is the latest example of misguided health care regulation and here is a brilliant post by Bryan Caplan pointing out that life’s most serious problems are not regulated at all, including (to use Uwe Reinhardt’s term) the most “mischievous” behavior.

Most irritating of all, however, is professor Reinhardt’s practice of trying to explain regulation by the use of totally baseless (and theory-less) claims while completely ignoring a real theory of regulation that I have offered to readers on more than one occasion.

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Can I do that? I would like to be able to. But the IRS won’t let me.

In another case a part-time worker has the opposite problem. She offers to take a cut in pay if we will allow her to join the NCPA health plan. I would like to be able to do that too. Ah, but the IRS won’t let me do that either.

When I say the IRS won’t let me, that’s not technically correct. It won’t stop me from doing these things; it will just impose draconian penalties if I do. Allowing even one employee to choose between taxable wages and non-taxed fringe benefits could enable the IRS to constructively treat our entire health plan as a taxable benefit and it could then tax every employee’s health insurance the same way it taxes wages. (For most of our employees, that would be a 25% tax; for some it would be a 45% tax.)

These problems affect men just as much as they affect women, of course. But the problems mainly arise because the most important economic and sociological change of the past half century (the entry of women into the labor market) is completely at odds with a tax law written years ago by men who thought that full-time male workers with stay-at-home wives is the way life would be lived.

I am woman, hear me roar 

There are other features of the tax law that are also relics of bygone assumptions. As a result, the highest tax rates in our economy are paid by women wage earners. In fact, women earning only modest incomes can pay taxes at rates that are twice those paid by such billionaires as Warren Buffet and Bill Gates. Consider that:

• When a woman leaves the home and enters the labor market, she will be taxed at her husband’s tax rate, even if she earns only the minimum wage. When all taxes and all costs are considered (including the cost of child care and other services she was previously providing as a homemaker), a woman in a middle-income household working a full-time minimum wage job can expect to keep only about 32 cents out of each dollar she earns.
• If the woman’s husband dies prematurely, Social Security will provide a modest benefit as long as she stays home and takes care of children; but if she works, the combined effect of direct taxes plus loss of benefits will create a marginal tax rate of 75 percent — leaving her with only 25 cents out of each extra dollar she earns.
• Once the widow’s children are grown, Social Security benefits will cease and she will be on her own to fend for herself; but if she previously responded to the system’s anti-work incentives, by remaining out of the labor market, she will now have to enter the market without job skills.
• If the woman receives government assistance, she will confront a newly reformed system that is supposed to encourage work; however, when explicit taxes are combined with loss of benefits, her marginal tax rate will be about 72 percent — leaving her with only 28 cents out of each dollar of wage income.
• When the woman reaches the retirement age she will once again qualify for Social Security benefits, but if she tries to supplement those benefits with wage income, special taxes on the elderly will make her marginal tax rate 50 percent higher than young people earning the same wage.

The tax law is not the only institution that is out of touch with the way modern families live. Here are some other examples:

• Both men and women workers pay the same unemployment insurance taxes, but because women are more likely to work part-time and because they voluntarily move in and out of the labor market more frequently (for example, to raise children or care for a parent), they are less likely to receive any benefits in return for the taxes they pay.
• If a woman temporarily leaves the work force to raise children and then returns years later, she will lose most of the credits she accrued and run the risk of being ineligible for Social Security disability benefits.
• Because Social Security taxes are levied on all earnings until capped at a high income level, dual-earner households generally pay considerably more in taxes than single-earner households, but they will get only a minimal increase in Social Security benefits.

Women are adversely affected by public policies in other ways. In contrast to some other developed countries, the United States encourages employers rather than government to provide such benefits as health insurance and pensions. Our private employee benefits system is not the result of free market forces, however. Instead, it has been shaped and molded by federal law designed to accommodate a full-time worker with a stay-at-home spouse and penalize any other arrangement. For example:

• Because they are more likely to work part-time, women are less likely to qualify for employer-provided benefits.
• Because they move from job to job and in and out of the labor market more frequently than men, women are more likely to be burdened by employee benefit programs that penalize job switching (e.g., lack of vesting in a pension plan).
• When people acquire health insurance and save for retirement on their own (not through an employer), the tax system is far less generous.

Many changes are needed to bring aging institutions into sync with the way people are living their lives in the 21st century. Here are a few suggestions:

• We need a fairer tax system for two-earner couples, ideally a flat tax that taxes all income at one low rate.
• The law should give the same tax relief for health insurance, retirement savings, etc. to everyone — regardless of whether they obtain the benefit at work or purchase it on their own.
• Employee benefits law should permit flexibility, making it easier for dual-earner couples to obtain higher wages rather than unneeded, duplicate benefits and for part-time workers to accept lower wages in return for more valuable health and retirement benefits.
• We need flexibility in labor law, making it easier for workers (especially parents with young children) to choose alternatives to the traditional 40-hour work week.
• We need to repeal laws that prevent employers from purchasing health insurance that is portable — so that people are not penalized when they switch jobs.
• If disability insurance and unemployment insurance were private and individually owned (the way they are in Chile), women would avoid most of the arbitrary unfairness of the current system.
• We need a completely new approach to the treatment of spouses receiving Social Security retirement benefits and widows receiving survivors’ benefits.

Unlike the left wing approach to “women’s issues,” these reforms do not assume that in order for some people to be successful we must limit the freedom or raise the taxes of others. Instead, we need to liberate women from outdated institutions that unfairly penalize them. Women in our society are capable of making choices that are right for them and they are perfectly capable of living productive, satisfying lives, provided that misguided public policies do not hold them back.

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Most of the media reports have been reasonably accurate, see The Hill and The Washington Post, but have missed the real potential in the study.

The media reports have focused on the study’s conclusion that if half the people with employer-based plans were in a consumer driven plan, the system-wide savings would be $57.1 billion. But this is a mid-range estimate that assumes an equal mix of HRA and HSA approaches. The study acknowledges that HSAs are far more cost-effective, and estimates that, if all of these people were in HSA plans the annual savings would be $73.6 billion.

Now that is a pretty big chunk of change, but even it likely underestimates the impact. The study’s authors write:

This estimate was based on cost reductions in the first year of consumer- directed plan enrollment and did not assume any reduction in cost trends for these enrollees.

First year savings are the least of it. The real value of consumer driven approaches is that trend is reduced and the savings mount up over time. The 2009 study by the American Academy of Actuaries, for one, found that the trend over time for CDHPs ranged from 12% to 17% lower than for traditional plans. (By the way, this new RAND study is one of the very few, if any, to cite the AAA study as a source.)

This difference in the experience of HRAs and HSAs is particularly important because this study relies on data from 59 large employers from 2003 to 2007. HSAs were signed into law in December 2003, and didn’t really go into effect until 2005. So the HSA experience studied here must have been very limited.

Importantly these savings do not accrue solely to employers. The study looks at out-of-pocket costs as well as premiums, and concludes that families themselves reduced their costs by over 20%. The authors write:

Savings derived from switching to consumer directed health plans could benefit both employers and employees. Inflation-adjusted health care costs have increased more rapidly than real wages in each of the past six decades. Reducing health care costs can boost output, income, and employment growth in US industries that provide employer-sponsored insurance to a large percentage of their workers.

So the savings are real and substantial, but what are the problem areas? The authors looked at several.

Are these savings due to selection? No, the authors controlled for that. They write:

Consumer-directed enrollees in these large employer plans spent less on health care than enrollees in traditional plans even in the year prior to their enrollment, and the estimates above controlled for this favorable selection into the consumer-directed plans.

Are “vulnerable populations” (high risk and/or low income) disadvantaged? They don’t seem to be.  While “nonvulnerable” families decreased spending by 20.9%, those with low incomes reduced spending by 17.3% and those with chronic conditions reduced it by 14.7%.

Do people cut back on necessary care? Here it is hard to tell. Inpatient care dropped by 22.1%, outpatient by 18.2%, and prescription drugs by 16.0%.  The drop in preventive care was much less, ranging from 2.7% to 4.7% for six different procedures. The authors note that prevention was fully covered in all these cases, so:

… Ongoing communication with plan enrollees may be necessary to improve their understanding and use of preventive service benefits.

They add:

One objective of consumer-directed plans is to encourage greater consumer shopping for health care. Our findings that reductions in spending occur through lower spending per episode, more use of generic versus brand-name drugs, less use of specialists, and lower inpatient hospitalization suggest that these plans do induce changes in treatment choices and not just access. Further research is required to determine whether these are appropriate changes, and our findings concerning preventive care demonstrate that more information is needed to improve consumer decision-making.

Once again, these authors have done some excellent research and we hope they continue this work. In particular, it would be very useful to find out more about the effects over time (how is trend affected?) and how effective are various forms of employee and patient education, support services, and access to information.

One of our main contentions has always been that people will navigate the system better as they become more accustomed to it. It would be useful to test that theory in real-world conditions.

Perhaps most importantly, this kind of quality research may persuade the so-called “research community” to finally put aside their partisan opposition and begin to take this trend seriously. It is the future of health care.

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In 2008, the average regulation received 56 days of OMB review. In 2009, the average regulation received 27 days of review.  In 2010, the average ObamaCare regulation received 5 days of review. The RIAs accompanying the regulations were “seriously incomplete, and they fell far short of federal agencies’ normal practice.” The economic impact of the resulting regulations was so poorly understood that the authors suggest that Congress should consider establishing a review agency that is independent of politics and can “review agency regulatory analysis according to widely accepted standards.”

Let’s Call the Whole Thing Off

As the chart below shows, poor analysis produced poor quality regulations.

Executive Order 12866 states that RIAs should “assess the systemic problem a regulation is supposed to solve, define the outcomes the regulation is supposed to produce for the public, examine a wide variety of alternative solutions, and assess the pros and cons (benefits and costs) of the alternatives.” An RIA is then supposed to be made available for public comment before a final rule is passed. The agency must consider public comment in formulating the final rule.

Rather than following the Executive Order, the “agencies decided on, wrote, and published the results without first publishing a proposal or RIA for public comment.” Specific analytical shortcomings include

• Benefits estimates that tended to be biased upwards
• Benefits estimates that were theoretically wrong, as when analysts confused transfers with efficiency benefits.
• Cost estimates that were biased downwards, usually due to a failure to consider entire categories of costs such as the efficiency losses associated with using higher taxes to finance a regulation.
• Net benefits estimates that were biased upwards, “in some cases with biases large enough to call into question whether the benefits of new rules exceed their costs.”
• Analyses that “ignored less-expensive alternatives that would be obvious to most health policy analysts.”
• Often cited benefits from increased “equity,” although the analytical effort was apparently so poor that the authors concluded that “When the word ‘equity’ appears at all, it is employed as a rhetorical embellishment rather than a serious category of analysis.”

In some cases, the regulations may impose costs that are higher than their benefits. Though the paper does not assess whether accurately calculated costs exceed accurately calculated benefits, it does find that The Early Retiree Reinsurance Program, the Pre-Existing Condition Insurance, and the Dependent Coverage for Children up to Age 26, “probably” generate more costs than benefits.  Rules requiring guaranteed issue and eliminating lifetime  benefit maximums “possibly” produce higher costs than benefits, as does the mandate to cover “preventive services” and the much ballyhooed, but undersubscribed, federal pre-existing condition pool. The relationship of net benefits to net costs in the rules for grandfathering health plans, the rules for claims appeals and external review processes, and the rules for calculating Medical Loss Ratios are considered “uncertain.”

The efficiency losses created by tax based finance are ignored both in the RIAs and in the public debate.  They are generally understood to be large and significant costs. Since 1992, the Office of Management and Budget has required federal agencies to assign a shadow cost for the lost production of 25 cents to every $1 of expenditures. The authors note that other analyses suggest that the “deadweight loss” from taxation, the losses that occur because taxes distort the signals sent by the price system, for each dollar collected are as high as 44 cents. For the Early Retiree Reinsurance program, ignoring deadweight losses understates costs by roughly 44 percent of the program’s estimated costs of $2.2 billion.

The losses from the increased moral hazard generated by ObamaCare’s Medical Loss Ratio regulations were also systematically ignored. The amounts in question are substantial. As the authors point out, health insurance fraud alone accounts for an estimated 3 to 10 percent of annual US health care spending. Only 10 percent of the estimated fraud is actually discovered and only 10 percent of those funds are actually recovered. In view of this poor success rate, general opinion seems to hold that the biggest cost saving from anti-fraud measures comes from preventing fraud in the first place.

The authors note that the current health system “massively underinvests in fraud prevention/detection.” In view of this, the officials writing ObamaCare’s Medical Loss Ratio regulations could have decided to exempt all spending on anti-fraud activities from the Medical Loss Ratio calculation. Instead, they wrote rules that penalize insurers who spent more on deterring fraud. For example, a health plan spending $15 in administration for every $100 in premiums would be in violation of the Medical Loss Ratio regulations if it spent another $1 to prevent $5 in fraudulent claims. Spending the extra $1 would cause its Medical Loss Ratio would drop to 83 percent ($16/$100) because the $5 in fraudulent claims would never be paid, and would therefore never be entered into the denominator of the calculation.

Though insensitive to fraud prevention, the RIA analysis of Medical Loss Ratios was exquisitely sensitive to convenient definitions of equity. For example, readers are informed that the rebates required under the regulation would lead to “less disparate MLRs and value to consumers across issuers and States.”

This, as the authors point out, is nonsense. “Why equal percentages of expenditures are equitable is not explained. Indeed, if we assume the real goal is to equalize health outcomes across states, the equity claim is questionable, because differences in costs, insured populations, or market characteristics across states might require unequal MLRs to achieve the same outcomes for patients; equal MLRs could exacerbate inequality of outcomes.”

The inequity generated by the subsidized rates for people in the federal pre-existing conditions program, was ignored. Because people have to be uninsured for 6 months before enrolling, individuals in states with high-risk pools are required to either stay in those pools and pay higher premiums or go without insurance for six months to qualify for the federal program. This, as the authors point out, “arguably penalizes consumers who are currently in state high-risk pools, which appears to be a source of inequity worth commenting on.”

Parts of the rules simply seem irrational. The rules on Grandfathered Health Plans entirely prohibit changes in coinsurance while allowing copays to rise by inflation plus 15 percent. What, the authors ask, “is the rationale for limiting coinsurance changes to medical inflation plus 0 percent?” They conclude that there is no logical justification for tilting the playing field in “favor of plans that have adopted a copayment structure. Regulators apparently did not even consider an alternative that would have treated such plans similarly” even though they could have adopted a less restrictive actuarial equivalence standard.

Why didn’t the government adopt the actuarial equivalence standard? The RIA analysts said that using actuarial equivalence was just too complex and costly. This excuse does not hold water. As the authors point out, actuarial equivalence is used in Medicare Part D. It has been used to evaluate Massachusetts Connector Authority Plan benefit structure since 2006. Even more embarrassing, ObamaCare actually requires its use in structuring plans offered in the health insurance exchanges.

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The answer is simple: it isn’t subsidized.

Every other form of insurance coverage gets massive subsidies. Obviously Medicare and Medicaid, being government programs, get most of their funding from taxpayers. Government spending on Medicare was $555 billion in 2011 and $387 billion on Medicaid in 2009. Employer-sponsored health insurance is also subsidized — to the tune of over $300 billion a year, according to the Congressional Research Service (CRS). This is because the value of coverage provided by the employer is “excluded” from employees’ income. Unlike wages, employees escape both income taxes and payroll taxes on this benefit. Even the uninsured are subsidized. The Kaiser Family Foundation found that, while the uninsured paid $30 billion for their own care in 2008, they incurred another $56 billion in costs, three-quarters of which was compensated for by government.

Only people who buy their own coverage in the individual market get no tax break whatsoever. Actually, even that isn’t quite true. In recent years the self-employed have been allowed to take a deduction of their health insurance premiums from their income, provided they make at least enough self-employment income to cover the expense. I haven’t been able to track down the value of this tax break, but because they don’t get to avoid the payroll tax the subsidy for the self-employed is still less generous than the complete exclusion from income of employer-sponsored coverage.

So who is left? Only those people who do not get coverage on the job, who are not self-employed, and who buy individual health insurance. These are the only people in America whose health insurance is not subsidized by the government.

Who are these unfortunates? They tend to be people of lower incomes. They may be unemployed or working only part time. They may be early retirees. If they are working, they are likely to be in low-paid jobs like retail clerks in small grocery stores, gardeners, busboys in restaurants, and the like.

Somehow the government has never seen fit to extend to these folks the kind of health insurance support the rest of us take for granted. Say what you will about ObamaCare, but for the first time in history it will provide some “premium support” to this segment of the population.

Unfortunately, ObamaCare leaps over many less drastic steps that might have solved the problem without the wrenching contortions imposed by this law. We might have, for example, improved the individual market without a mandate.

This might have been done simply by extending the same sort of subsidy to people who buy their own coverage as we give to those with employer-based coverage. Or, because the tax treatment of employer-based coverage is extremely regressive (higher-income people get more benefit than those with lower incomes), we might have reformed the whole thing to extend the same dollar amount to all who purchase health insurance. See John Goodman’s recent post on this issue. Or we might have provided a sliding scale subsidy to all who are covered, so that lower-income citizens get more help than those with higher incomes.

But let’s assume for a minute that all private health insurance is treated the same way for tax purposes, whatever that treatment might be. What would happen then?

For most people nothing would change. Employers who find value in providing coverage would continue to do so. These might include companies in very competitive labor markets, or companies that are quite large and able to effectively pool their own risks, or companies with strong commitments to improving the health of their workforce through wellness programs and the like.

But, many other employers do not benefit from providing coverage. They may not have expertise on staff, or they might have high turnover, or be in relatively low-wage industries where cash wages are more attractive than insurance benefits. These companies could stop providing health insurance (many already have) and contribute to the cost of coverage for their employees instead.

The employees would no longer be disadvantaged by the tax code because the same tax benefit would be available whether they secured their own coverage or got it from the employer. This would be particularly beneficial for two-income families. They would be able to merge the resources of two employers into a single program for the entire family.

But the greatest benefit would accrue to people who currently struggle to maintain their individual coverage. They may be only marginally attached to the workforce or work in jobs where the employer has no interest or few resources to finance health care. They might also be retired or physically unable to work. In all of these cases there would be tax support available that wasn’t there before.

How would the insurance industry respond?

This is where our scenario gets really interesting. Let’s assume that one-third of the current employer market switches to individual health insurance, in many cases with a contribution from the employer along with a tax credit from the government.

That would mean 50 million new customers in the individual market. Most of these people would be well-subsidized and relatively healthy since they are at least able to work. Would that be an attractive market? You betcha it would!

Suddenly the individual market would not be confined to the handful of people who simply cannot qualify for employer-sponsored coverage — people with sketchy work and health histories and dubious finances. Suddenly there would be a very large number of potential customers who are gainfully employed and financially secure. The insurance industry would be eager to enroll them.

The industry would immediately take several steps to gain a share of this attractive market;

• It would simplify the enrollment process to avoid alienating prospective customers.
• It would design benefit programs to be more appealing to specific market segments.
• It would start advertising directly to consumers, much as the auto insurance industry does today.
• New and innovative competitors would enter the market.
• It would relax underwriting restrictions because the cost of underwriting would not be justified by the risk profile of the pool of applicants.

The last point needs to be explained a bit. As we’ve said, the current pool of applicants for coverage is very small and tends to be financially insecure and often of poor health. Carriers are cautious with this population because a handful of expensive people can have a large effect on the small enrollment base and the proportion of high risks is greater than in the general population. It is worth the expense of medical screening to protect the enrolled population from the cost of a few high-cost cases.

Once the pool of applicants is more like the general population it is no longer worth the cost of screening 100% of the applicants to keep out the very small number of high risks. Medical screening also tends to alienate the good risks the company would like to attract.

There might still be a very simplified health statement required, but this might be confined to a checklist of ten (or so) questions looking for active cases of cancer or heart disease. These applicants would be referred to the high-risk pool. Every voluntary insurance market has some form of high-risk pool, usually referred to as a “residual market.”

This simple change in tax policy would lead to a much more competitive and innovative insurance market, and would make health insurance coverage far more affordable to people not benefitting from employer-sponsored care.

It could lead to expanded insurance coverage as ObamaCare hopes to, but with far fewer regulations, mandates, and complexity, and much lower system-wide costs.

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Chart 1 shows the share of health spending controlled directly by patients (also known as “out-of-pocket” spending) in ten developed countries, including the United States, from 1988 through 2008. (Not all countries are represented for the entire period.) Switzerland, a country widely praised for its health care, allows patients to control significantly more of their health dollars than any other country does. Out-of-pocket spending in Switzerland has fluctuated around one third of total health spending since 1998.

Everybody all over the world,
In every nation.

In all other countries, out-of-pocket spending has clustered around 15 percent of total health spending. However, countries are showing different trends. In the late 1980s, the United States allowed patients to control more health spending than any other country, except Switzerland. By 2003, it had dropped to the bottom of the pack.

Chart 2 shows the change in the share of out-of-pocket spending for all countries for which data is available for the entire two decades. It shows unequivocally that the United States has been moving in the wrong direction: Removing health dollars from patients’ control and giving it to government and insurers to spend. The share of U.S. health spending controlled directly by patients has dropped by almost half in twenty years. No other country comes remotely close to this failure of consumer direction.

Indeed, only three of the nine countries have experienced a drop in patient control. The next worst is Switzerland, for which the drop was only twenty percent. As noted above, Switzerland has an extraordinarily high share of direct payment, so a loss of consumer sovereignty, while worrying, is less of a concern than in countries like the United States where the share of health spending controlled by patients was already low in the 1980s. Ireland showed a marginal drop in patient control over the period, with out-of-pocket spending as a share of total health spending dropping by about eight percent.

In every other country, the share increased or remained stable over the period. Tiny Luxembourg experienced a large jump in patient control around the turn of the century, but this was from a very low base. (Out-of-pocket health spending jumped to 11.8 percent of total health spending in 2000 from just 7.4 percent the year before.)

In other countries, the increase in patients’ share of health spending clustered around 15 percent over the period. Even in Canada, where government continues to assert monopoly control over residents’ access to health care, the share of health spending controlled by patients directly remained unchanged. As a result, Canadians now enjoy more direct control over their health dollars than Americans do!

The lesson is clear: The United States continues to experience a long-term trend of loss of patients’ control of health spending. Attempts to reverse this with tools such as Health Reimbursement Arrangements, Flexible Spending Arrangements, Medical Savings Accounts, and Health Savings Accounts have not resulted in systemic change.

As a result, Americans control less of our own health spending than do residents of other developed countries. After ObamaCare is defeated, reversing his long-term trend must be the top priority of the real health reform that replaces it.

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In what follows, I will review some of the advantages and disadvantages of the various health savings options, based on a recent post of mine at Health Affairs. But let’s begin by jumping to the bottom line: none of them is ideal. As Mark Pauly and I explained in Health Affairs some time ago, an ideal account is one that does not distort incentives.

In the current period, people must choose between spending on health care and spending on other goods and services. When saving comes into play, people must choose between current and future health care and between future health care and future other goods and services. An ideal savings account is one that keeps all these choices on a level playing field with respect to the tax law. I call this account a Roth Health Savings Account, or Roth HSA.

All the things I could do
If I had a little money. 

There are two ways people can insure for medical expenses: third party insurance and individual self-insurance. Under the former, a third party (insurance company, employer or government) pays the expenses. Under the latter, people must save and pay the expenses directly, from their own resources.

This division of insurance responsibility is a normal aspect of every insurance market. In health care, however, the tax law complicates our choices. In general, employers are able to pay third party insurance premiums with pre-tax dollars (untaxed to the employee), whereas out-of-pocket payments by patients must normally be made with after-tax dollars. A second problem is that most families are not in the habit of saving while they are healthy for expenses that will arise with an unexpected illness.

To overcome these two problems, the law allows people to save on monthly basis in tax-favored accounts by using several vehicles. Unfortunately, the rules governing these accounts are arbitrary and inconsistent — reflecting no clear public policy purpose.

Comparing the Accounts. With all the acronyms in use these days, readers can be forgiven if they get confused. The table below gives an overview, but let’s start with the two most popular accounts: Flexible Spending Accounts (FSAs), which hold funds available only for the current period, and Health Savings Accounts (HSAs), with funds that roll over from year to year tax-free. In general:

• Both accounts are established by employers, and employees can make pre-tax deposits to them to pay medical expenses not covered by the employer’s health plan. The HSA contribution limits are currently $3,050 (individual) and $6,150 (family). Starting January 1, 2013, FSA deposits will be limited to $2,500 per employee.
• Employers are allowed to make deposits to both accounts; the HSA deposit is limited, but there is no limit to how much they can deposit in an FSA.
• HSAs must be combined with rigidly designed health insurance plans (with minimum and maximum deductibles, limits on out-of-pocket costs, etc.); in contrast, the FSA account is completely flexible — it can wrap around any health plan.
• Employees have a more secure property right in their HSAs; they can take their HSA funds with them when they leave an employer, but they have no legal right to unused FSA balances.
• The FSA account holder can never take the money out in cash; by contrast, employees can withdraw their HSA balances if they pay ordinary income taxes and a 20% penalty if the withdrawal is before age 65.
• Unlike the HSA approach of use-it-or-save-it, FSA accounts are use-it-or-lose-it; any account balance left at year end (or after an extra 2½ month grace period) is forfeited.

Although employers are allowed to make deposits to FSAs, few take advantage of this opportunity. Because of the use-it-or-lose-it feature, these plans are additions to, rather than integrated parts of, employer health plans. Because the deposits are tax free, they almost certainly add to health care spending, as they are currently structured. They encourage employees to purchase designer eye glasses with pre-tax dollars, for example, rather than purchase other goods and services with after-tax dollars. At year end, employees will view almost any kind of wasteful spending as preferable to forfeiting the money left in the account.

Why are these accounts use-it-or-lose-it? Apparently this feature is the result of a Treasury Department ruling, not the result of any act of Congress.

Here is how Flexible Spending Accounts and Health Reimbursement Arrangements (HRAs) differ from each other:

• Like FSAs, the HRAs are also created by employers and they are completely flexible, in the sense that they can wrap around any health plan.
• Unlike FSAs, HRA balances roll over from year-to-year.
• Like the FSA, HRA balances can never be taken out in cash (so they are long-term use-it-or-lose-it).
• Finally both FSA and HRAs are notional accounts — in contrast to the HSA, no money is actually deposited in an employee-earmarked account — and employers can abolish the employees’ claims if they leave the company.

The 401(k) Option. Although 401(k) plans were never designed to function as a health account, the law does allow employees to make a hardship withdrawal for a large medical bill. The withdrawal must be for an immediate financial need for which the employee has no other funds available and it is subject to a 10 percent penalty plus federal income taxes.

Employees may also borrow from their 401(k) and this could be a source of funds to pay medical bills. Plans with loan provisions generally allow an employee to borrow up to half of a vested account balance, but not more than $50,000. Federal law requires that the borrower be charged a “reasonable rate” of interest, which is normally fixed at the prime rate plus 1 percentage point and the loan must be repaid within five years.

The primary disadvantage of taking a 401(k) loan is the loss of compound interest and dividends that would have accrued if the money had not been borrowed. Moreover, the interest paid back into the account is unlikely to equal the interest earned by 401(k) investments. For example, if an account were earning a market interest rate of 6.25 percent, and a 47-year old plan holder borrowed $10,000 at a lending rate of 3 percent for two years, he would have $80,000 less at retirement (age 67) than if he had not borrowed.

Making Flexible Spending Accounts Better. There is something rather simple the Obama administration could do that would have a very large impact on health care spending. Apparently, this is something that can be done administratively, without Congressional action. The simple step: Allow deposits to Flexible Spending Accounts (FSAs) to roll over at year end and grow tax-free.

Currently, there are about 25 million people with an HSA or HRA account (roughly evenly split) and another 35 million people with FSAs. That means that over half the people with a health account have an incentive to spend rather than to save. If FSAs could roll over and become use-it-or-save-it accounts:

• There would be a huge immediate impact on the incentives of the 35 million current account holders; instead of end-of-year wasteful spending, they would be tempted to save for more valuable future health care spending.
• Employers across the country would consider integrating these accounts into their health plans, making employer contributions to them and experimenting with new health plan designs.

Moreover, employers and their employees would have a vehicle much better than any option currently available to them to control health care spending:

• FSAs could be combined with high deductibles, allowing employees to directly control, say, the first $2,500 of spending without all of the pointless restrictions that hamper the usefulness of HSAs.
• FSAs could be created to allow employees control of whole areas of spending, say, all preventive care and all diagnostic tests — services for which individual discretion is both possible and desirable.
• FSAs could be created for the chronically ill — allowing, say, diabetics or asthmatics to manage their own health care dollars, much as home-bound, disabled Medicaid patients manage their own budgets in the Cash and Counseling programs.
• FSAs could be combined with value-based purchasing insurance plans — where the insurer only pays, say, for certain drugs, doctors and hospitals, but allows patients to add money out-of-pocket and make other choices — thus allowing the development of a real market for more expensive health care services.

The Potential Impact of High Deductibles. Every serious study that has ever been done on the subject has found that patients spend less on health care when they are spending their own money. The latest study by the RAND Corporation estimates that families with high deductible plans and Health Savings Accounts spend about 30% less than families with conventional insurance. And that’s with HSA plans designed by Congress. Think how much more effective the accounts could be if they were designed by the marketplace.

Achieving the Ideal. Finally, good as the idea of FSA rollovers is, it is still short of the ideal. For starters, people need to have the option to withdraw cash from their FSA and spend it on non-health care goods and services. Beyond that, we should consider more fundamental reform.

As the table shows, today we have an array of account options — each with advantages and disadvantages when compared to each other. This reflects the complete lack of a public policy purpose. Why should the contribution limit be $3,050 for an HSA, $2,500 for an FSA and unlimited for an HRA? Why should people be able to withdraw cash from the HSA, but not from the FSA or HRA?Why are FSAs and HRAs flexible, while HSAs are not?

As noted, the ideal account is a flexible Roth HSA. The Roth account involves after-tax deposits and tax-free withdrawals. It is the account that is most compatible with subsidizing health insurance with lump sum tax credits — an approach advocated by Sen. John McCain and incorporated in the Coburn/Burr/Ryan/Nunes health reform bill.

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• Health reform (ObamaCare) will save taxpayers $200 billion in the Medicare program through 2016.
• About 90% of these savings will be produced by lowering “excessive payments” to Medicare Advantage plans, lower payments to doctors, hospitals and other providers to reflect their “improved productivity,” and through efficiencies gained by what is learned from “demonstration projects.”
• The demonstration projects include pay for performance, bundling, Accountable Care Organizations, and other frequently discussed ideas.

But whereas the Trustees report is expected to be a serious document, reflecting accepted accounting principles, the administration’s document was clearly a piece of political propaganda — one that stretched the truth so much that the word “spin” would be a charitable description. For example, the administration’s document failed to mention that:

Seemed like the real thing only to find
Much of mistrust, love’s gone behind

• The Congressional Budget Office has studied the demonstration projects on three separate occasions (here, here and here) and each time has concluded that they are producing no serious savings and are unlikely to do so in the future.
• Medicare’s Actuary has determined that reductions in payments to Medicare Advantage plans will not only result in lower benefits for the one in four seniors who are in these plans, but that about 7 ½ million enrollees will actually lose their coverage and have to seek more expensive Medigap insurance elsewhere.
• Medicare’s Office of the Actuary also has concluded that the projected savings are unrealistic and will not materialize — since they will result in hospital closings and seniors’ inability to find accessible health care — a judgment reaffirmed in the Chief Actuary’s own statement in the latest Trustees report.
• Even if the $200 billion in savings did materialize, it would not be a saving to taxpayers; instead, these savings have already been pledged to create a new health insurance entitlement for young people — leaving taxpayers just as burdened as they were before.
• The administration’s report also claimed that health reform has created $60 billion in new benefits for seniors, without mentioning that for every $1 of new spending beneficiaries will lose $10 of spending somewhere else.

On lower payments to providers, Chief Actuary Richard Foster produced a chart for the Trustees report showing what “$200 billion in savings” actually means. The projection assumes that:

• Beginning in 2013, payments to physicians will drop by 31% to reach Medicaid levels.
• Going forward, Medicare payments will fall further and further below Medicaid fees, with each passing year.

Remember, the biggest problem for Medicaid patients is finding a doctor who will see them. As a result, they frequently must turn to community health centers and the emergency rooms of safety net hospitals, where rationing by waiting is common. What we can look forward to is a world in which seniors (from a financial point of view) will seem less desirable customers than welfare mothers.

What about the administration’s preferred organizational form of health care delivery — Ac­countable Care Organizations? They have been rejected by the nation’s leading health plans, including those that the administration points to as examples of high-quality, low-cost service. What about other demand-side reforms: forcing/inducing/coaxing providers to adopt electronic medical records, to coordinate care, to integrate care, to manage care, to emphasize preventive care, to adopt evidence-based medi­cine, and so on?

In theory, you can make a reasonable argument for each of these ideas. Who can deny that piecemeal medicine, with dozens of doctors making in­dependent decisions about various aspects of a patient’s care, is likely to be wasteful? Wouldn’t it be better if the doctors all got together and coordinated their decisions? Doesn’t integrated care make more sense than nonintegrated care? Wouldn’t integrated care be easier if there were a medical home that kept all the patient records in one place? Wouldn’t it all be more efficient if all the doctors could go to a computer screen and see what every other doctor has done to the patient and is planning to do?

I don’t have a problem with any of this. In fact, I can point to ex­amples where some of this actually works. My problem is that wherever I find any of these techniques working, they originated on the supply side of the market, not the demand side.

Whenever these ideas are foisted on physicians by a government pilot pro­gram or by some other third-party-payer bureaucracy, they not only don’t work, they often backfire. Electronic medical records and other electronic informa­tion systems seem to work, and work well, when they are adopted by doctors to solve their specific problems. (After all, isn’t that how information systems get adopted in the rest of the economy?) They do not work well when they are designed and imposed by the buyers of care.

On the supply side, we have the islands of excellence (Mayo, Intermountain Healthcare, Cleveland Clinic, etc.). On the demand side, we have a whole slew of experiments with pay-for-performance and other pilot programs designed to see whether demand-side reforms can provoke supply-side behavioral improve­ments. And never the twain shall meet.

We cannot find a single institution providing high-quality, low-cost care that was created by any demand-side buyer of care. Not the Centers for Medi­care and Medicaid Services, which runs Medicare and Medicaid. Not by any private insurer. Not any employer. Not any payer, anytime, anywhere. As for the pilot programs, their performance has been lackluster and disappointing.

What about grading hospitals based on the quality of care? One recent study finds that Medicare’s reporting has had almost no impact on mortality. Another survey finds that quality report cards not only don’t work, they may do more harm than good. What about paying for results? The latest study of pay-for-performance finds that doesn’t work either. Accountable Care Organizations? The latest results show no reason to be hope­ful. Electronic medical records? The latest survey of all the academic literature shows they don’t improve quality or reduce costs. Indeed, a new study in Health Affairs found that when doctors can easily order diagnostic tests online, they tend to order more tests — increasing costs.

The fundamental problem in health care is that people in the system face perverse incentives. If we want to change the perverse outcomes, we must change the incentives that lead to them. Nothing else is going to work.

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The promise by supporters of the Affordable Care Act that people will no longer be turned down for coverage is an example. This is already illegal in all but the individual market. Even there, denials are a miniscule issue. According to a recent report by Milliman, based on new reporting by carriers required by the National Association of Insurance Commissioners (NAIC), there are only 10,300,000 people covered by individual health insurance – three percent of the population of the United States. And denials would happen only at the time of application for coverage, not after someone is already covered. The trade group America’s Health Insurance Plans (AHIP) reports that 87% of all applicants for individual coverage are accepted. Out of 1,763,000 applicants who were medically underwritten in 2008, AHIP reports that 223,000 were denied coverage. This is less than one tenth of one percent of the country’s population.

I beg your pardon,
I never promised you a rose garden.

The other criticism of the individual market is that it is too expensive. Milliman’s analysis of the NAIC reports finds that is simply not true. In fact, the premium per member per month for individual (non-group) coverage is $211.67, while the small group premium is $333.25 and large group is $333.74.

Milliman also finds that the individual and small group markets have similar administrative costs on a per member/per month basis ($40.49 and $43.82, respectively), but both are higher than large group ($31.29), mostly due to “distribution costs” (marketing.) But because premiums are lower for individual coverage, similar expenses result in higher percentage of premiums. Thus, the individual market has a lower loss ratio (80.9%) than small group (83.7%) or large group (89.3%).

What about market domination? Milliman finds there are three states where a single carrier has 90% or more of market share in the large group market, two states for the small group market, and not a single state in the individual market. The number of states where a single carrier has 60% or more is 21 for large group, 17 for small group, and 15 for individual.

So what’s going on here? The individual market is somewhat more competitive, has similar administrative costs, and considerably lower premiums than the small group and large group markets. Yet it is widely disparaged. Why?

The biggest reason is denials of coverage for new applicants. Only seven states require companies in the individual market to accept all applicants (guaranteed issue), but 33 of the remaining states have a high-risk pool that will enroll people who are denied, and for the rest, Miliman reports:

… the state may designate an insurer of last resort, have a specified product that is issued on a guaranteed basis, or require that each market participant insure a quota of high-risk individuals.

Now, it may be that these risk pools are underfunded and too restrictive, but the insurers can hardly be blamed for that. That is the responsibility of state legislatures. And it hardly seems rational to turn the entire health care system on its head to solve a problem that affects much fewer that one-tenth of one percent of the population.

The other problem, of course, is that benefits in the individual market are less generous than in the group market. These plans very often don’t cover prescription drugs or maternity, or require a separate rider for these benefits. But if the market wanted to buy coverage for these benefits, it is certain the insurers would be happy to sell them. But, when people buy their own coverage they tend to be more cautious in getting value for their money, and don’t load up on things they don’t think they will need.

The biggest problem in the individual market is that it isn’t subsidized, and we’ll get into that next time.

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A recent post of mine was paean to a proposal by Sens. Tom Coburn (R-OK) and Richard Burr (R-NC), along with Reps. Paul Ryan (R-WI) and Devin Nunes (R-CA). That bill, in turn, was based on an idea that Mark Pauly and I proposed in a Health Affairs article more than a decade ago. It was also roughly the plan endorsed by Sen. John McCain in his presidential campaign in 2008.

Professor Reinhardt in a post at The New York Times Economix blog found much to like in these ideas, especially when modified by my proposal to make Medicaid available as a public plan alternative to private insurance. He also raised some additional questions that I want to address here.

Parenthetically, I find that it’s not that hard for economists on the left and right to agree on health reform. The reason: economists are naturally sensitive to incentives. They don’t like reforms that leave people with perverse incentives to do antisocial things. Once you are determined that the incentives have to be right at every margin, a lot of things begin to quickly fall in place.

You may say I’m a dreamer,
But I’m not the only one.

In what follows I want to address the fundamentals of health reform in the context of five choices people must make. Much of what I have to say is based on my Journal of Legal Medicine article, “Applying the ‘Do No Harm’ Principle to Health Policy.”

The Choice to Insure or Be Uninsured. In any rational health care system, public policies don’t encourage people to choose to be without health insurance. But for millions of people, that is what we are currently doing. Under the interim measures (2010 to 2014) of the Affordable Care Act (ObamaCare) those perverse incentives for some people have become even worse. How does that work?

Currently we are “spending” close to $300 billion a year on tax subsidies for private health insurance. These subsidies primarily consist of the ability of employers to pay insurance premiums with pre-tax dollars. As a result, government is effectively paying almost half the cost of the insurance for many middle-income families. Yet people who do not have access to employer-provided coverage get very little help from government when they buy insurance on their own. For the most part, they must purchase insurance with after-tax dollars — effectively making the after-tax cost of insurance twice as high as it is for their cohorts who get insurance at work.

What happens to people who stay uninsured? Estimates differ, but I’m going to guess that the uninsured get about $1,500 in “free” (uncompensated care) per person per year. Granted, the “free care” system is uncoordinated, largely disorganized and probably inadequate. Yet it amounts to de facto public insurance worth about $6,000 for a family of four.

Think about that for a moment. For millions of people, public policy does nothing to encourage the purchase of private insurance. But if they choose to be uninsured, they can count on a system of public and private charity that is actually quite valuable. Further, people don’t actually have to rely on free care once they become ill. A host of federal and state regulations has made it increasingly easy for people to get health insurance “after the fact” for the same premium a healthy person would pay. Under an interim measure, ObamaCare even establishes federal risk pool insurance — guaranteeing insurance to anyone, regardless of health condition, for the same premium a healthy person would pay after a six month wait!

The wonder is not why there are so many who are uninsured. The wonder is: why aren’t there even more?

The economist’s solution: never make uninsurance more attractive than insurance.

Here is my most recent iteration of the first step toward a more rational approach. By replacing all existing tax and spending subsidies and by making certain tax breaks (like the $1,000 child credit) conditional on proof of insurance, I believe we can offer everyone a refundable tax credit of $2,500 per adult and $1,500 per child — or $8,000 for a family of four — to be applied to the purchase of private health insurance.

If they turn this offer down — and many will turn it down — the uninsured will pay higher taxes than someone at the same income level who chooses to claim the credit and obtain insurance. You can think of these higher taxes as the penalty for being uninsured. All unclaimed tax credit money — and this is important —  should be made available to a safety net institution in the area where uninsured people live to serve as a source of funding in case uninsured patients cannot pay their medical bills.

I call this approach “public policy neutrality,” since it commits the same number of dollars, regardless of the choices people make. Further, I believe such an approach qualifies as “universal coverage.”

The idea that unclaimed tax credits should go to safety net institutions is critical, in my opinion. Its absence is a major flaw in ObamaCare, in RomneyCare and in the Republican plans mentioned above.

Professor Reinhardt asks if $8,000 is enough, considering that family coverage for the average employer costs more than twice as much. Of course, it is more than the subsidy the average family gets from the government under the current system. More importantly, the current subsidy is open ended. The federal tax subsidy pays from one-third to one-half of each dollar of wasteful coverage for the average employee. That means that employees have an incentive to obtain insurance even if it is worth only half of what their employer pays for it. Under the fixed-sum tax credit proposed here, however, each additional dollar of wasteful spending, at the margin, is a dollar the employee could use to purchase other goods and services.

The typical employer plan today covers every doctor and every facility that employees have ready access to, even though costs vary radically, as does quality. The plans pay seven times as much for an MRI scan for one employee as they pay for another.

Previously I have estimated that employers could cut their health care costs in half without sacrificing quality by (a) taking advantage of value-added purchasing and domestic medical tourism, (b) letting employees control all of their primary care dollars and (c) letting most chronic patients manage their own health care dollars (a la the Cash and Counseling program. Given appropriate incentives, many might decide to try this approach.

The Choice between Public and Private Insurance. I won’t review all of the evidence here, but there is substantial empirical support for a proposition that I’m sure most people probably believe anyway: Medicaid is worse than private insurance. In fact, there is some evidence that being on Medicaid is worse than being uninsured. Regardless of its quality (which probably varies from place to place), I have never understood why so many on the left want to segregate poor families into a health plan where the single biggest problem is finding doctors who will see them.

At a minimum, we should be neutral between public and private insurance. Everyone on Medicaid should have the opportunity to apply her allocation of Medicaid funds to a private plan, including employer plans and plans purchased in the marketplace.

I think the surprise for Professor Reinhardt was my willingness to reverse the process and give everyone in the private sector the opportunity to join Medicaid. To continue with the above example, a family of four should be able to use its $8,000 refundable tax credit to apply for Medicaid insurance. I suspect that Uwe would like to require Medicaid to accept the family for that amount. I would prefer to leave Medicaid programs free to charge a higher total premium, perhaps as high as 10% of family income.

In any event, Medicaid will always be an unattractive alternative to private insurance for most people.

The Choice between Employer Sponsored Insurance and Individually Purchased Insurance. As noted, federal tax subsidies pay for as much as half the cost of employer purchased insurance, while people who purchase their own insurance get very little tax relief. To make matters worse, almost every state makes it illegal for employers to buy individually owned insurance with pre-tax dollars. That means we have effectively outlawed the type of insurance most employees want and need: insurance they own and that travels with them from job to job and in and out of the labor market.

Under ObamaCare things will get worse. All of the inequities and inefficiencies will remain for above-average income families. But for low-income families the bias in federal tax subsidies will be reversed. A family at 133% of poverty will be able to get a subsidy in a newly created health insurance exchange that is as much as $20,000 higher than a family at the same income level getting insurance at the place of work.

Clearly this makes no sense. Worse: if left in place, this bizarre subsidy system will lead to a completely restructuring of American industry. Businesses will dissolve and reform, not in response to economic factors, but in response to the way government subsidizes health insurance.

Under the reform I am proposing, everyone will get the same subsidy regardless of where the insurance is purchased. If insurance is purchased on a level playing field, employers will not get involved unless they have a comparative advantage in providing insurance. Perhaps some large companies do. Most small ones do not.

The Choice between Third Party Insurance and Individual Self-Insurance. There are essentially two ways to insure against risk: pay an insurer to take the risk or self-insure, say, by putting money aside in a savings account. In health care, the insurer is often referred to as the third party (the first two parties are the doctor and the patient). Since medical expenses tend to be irregular and since most families are not accustomed to saving for them during periods of good health, my colleagues and I have proposed putting aside money every pay period in a Health Savings Account (HSA) or a Health Reimbursement Account (HRA), although the deposits are “notional” in the latter case.

For most of the post-World War II period, federal tax policy subsidized third-party insurance and penalized individual self-insurance. That is because employers could pay health insurance premiums with pre-tax dollars, whereas employees had to pay medical expenses directly with after-tax dollars. The advent of HSAs and HRAs over the past decade has leveled the playing field considerably, but the law is still too restrictive. For example, the HSA rules more or less force people into plans with high deductibles and sometimes coinsurance above the deductible as well. The problem with deductibles is that incentives are excellent when you are below the deductible limit, but disappear entirely when you are above it. The problem with a 20% coinsurance rate is that people have an incentive to over-consume —until health care is worth 20 cents on the dollar.

Elsewhere I have argued that ideal health insurance would dispense with deductibles and copayments and carve out entire areas for complete patient control. For example, patients should in general directly manage all their primary care dollars, including most diagnostic screenings. Chronic patients should be given the opportunity to manage their own care as well as the dollars that pay for that care.

Clearly, the market needs to be free to combine the two forms of insurance in creative ways without artificial restrictions. Also we need to re-think how we are subsidizing self-insurance. Mark Pauly and I proposed the Roth approach, under which deposits are made with after-tax dollars and withdrawals are made tax free. This levels the playing field between health care and other goods and service in the current period, in the future and between current period choices and future choices.

Choices in the Market for Risk. The single biggest mistake we have made in the market for medical care is to completely suppress the price system. As a result, no one ever sees a real price for anything. No doctor, no patient, no employer, no employee, etc. Similarly, the single biggest mistake we have made in the market for health insurance is to suppress the ability of insurers to accurately price risk.

Consider life insurance. If you develop cancer while you are uninsured and then try to buy life insurance you will find that it is very expensive. You might be denied coverage altogether. But if you buy the insurance while you are healthy and then get cancer you are protected. The insurer cannot cancel your policy or charge you a higher premium because of your illness. And since life insurance is portable, you are protected until you die. Cancer is what health insurers call a “pre-existing condition,” and in buying life insurance you are insuring against the unfortunate possibility that you might develop a pre-existing condition.

People don’t normally switch from one life insurer to another. But suppose one insurer (company A) bought a block of business from another (company B). In looking over the people with coverage, the two insurers would note that some people are paying a premium that is above the true actuarial value of their insurance and some are paying a premium that is below theirs. Individual health conditions change over time, but the premiums increases stay the same for all the members of the same pool. Given that fact, insurer A would pay more for the individuals who are overpaying (because they are profitable) and less for individuals who are underpaying (because they are unprofitable).

This very sensible arrangement is what doesn’t happen in the health insurance market, however. If a cancer patient leaves plan B and enrolls in plan A we require A to accept him for no more than the premium a healthy person would pay. In essence, we allow B to keep all the premiums the individual has been paying (perhaps for many years) and expect A to pay all the medical bills. This type of regulation destroys any possibility of, say, a vibrant market for cancer care — or any other kind of expensive care, for that matter. Instead, insurers will try to avoid the sick and attract the healthy. After enrollment, they will face perverse incentives to overprovide to the healthy and under provide to the sick.

John Cochrane has shown that it is possible and practical to structure health insurance so that people can insure for pre-existing conditions. Such a market would replace perverse incentives with good ones.

An adjunct to all of this is that we cannot allow people to game the system. That principle is already recognized under Medicare. Seniors are penalized if they fail to insure when they are eligible for Medicare Part B, Medicare Part D and for Medigap insurance. In other words we don’t allow people to avoid paying premiums while they are healthy and then enroll with impunity after they get sick.

Strangely, there are no similar penalties built into ObamaCare. People can stay uninsured while healthy and enroll after they get sick for the same premium everyone else is paying. There is a penalty for being uninsured. But the penalty is a small fraction of the premium savings people will enjoy if they decide to remain uninsured.

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