Risk and the Affordable Care Act

Storm-tossed ship at sea

Life is risk. Only inanimate objects need not deal with it.

All organisms have evolved ingenious ways to manage risk (or become extinct as a penalty for not doing so).  A squirrel buries its acorns in multiple locations to avoid starvation if a single cache were compromised. Field mice use a keen sense of smell to locate food under cover of darkness. Early humans, while successful hunters, learned to avoid SabreTooth Cats (the South American variety having 12 inch canines and weighing in at 1,000 pounds).

As mankind’s civilization became more robust, the daily risks of predation and starvation faded. The business of trade created a huge new requirement for risk management. Storm tossed seas, brigands, and shifting desert sands imperiled many a caravan and convoy. Trade was risky and techniques evolved to manage it. Four thousand years ago, the Chinese divided up shipments over many vessels when traversing dangerous rapids, a technique possibly borrowed in concept from squirrels.  All of these human and animal techniques are a form of insurance, a method to protect against risk.

The first hint of commercial insurance emerged nearly 3,000 years ago when Babylonian merchants paid a premium on their cargo loans in exchange for a promise that the loan would be discharged if the cargo were lost or stolen. The premiums could be steep, but the expense was far preferable to a total loss.

In the United States, commercial insurance was pioneered by, perhaps not unsurprisingly, our own Benjamin Franklin. As well as having invented the Franklin stove, Ben also developed a means to insure property owners from fire losses. The concept was to spread the risk of fire over a large population, with owners paying premiums into a common pool. Franklin as well developed the concept of risk mitigation by refusing to insure high risk properties (all-wooden structures). This was intended to modify the behavior of builders and buyers, and it worked.

Later in the 19^th and 20^th centuries, commercial insurance companies did much to reduce the risk of fire by sharing statistics with state and local governments and suggesting building codes to reduce the incidence of accidental fires. By refusing to insure noncompliant properties, the industry was able to influence builder and buyer behavior and further reduce the risk of loss. During this time, commercial insurance expanded widely beyond property to include coverage for life and accidents. The key was statistical analysis by actuaries who determined risks, probability of losses, and set the required premiums.

Health insurance evolved slowly beginning early in the last century. Medical fees then were typically handled directly between the patient and the provider (doctor or hospital). This could be financially devastating if a serious or chronic health condition occurred. Baylor Hospital in Dallas Texas approached the problem by offering a prepaid plan where participants (subscribers) would be assured up to 21 days of hospitalization for $6 per year. This evolved into the Blue Cross Plans.

At about the same time, lumber and mining camps in the Pacific Northwest wanted to provide medical care for their employees (it’s hard to think of more dangerous occupations). The camp owners paid monthly fees to “medical service bureaus,” groups of physicians, who then provided medical services to the lumberjacks and miners. In 1939, the first Blue Shield Plan was established in California based on this model.  In 1982, the hospital and doctor groups joined to become the Blue Cross and Blue Shield Association.

Broad employer-based health insurance emerged as a consequence of government wage controls during World War II. Competing for scarce labor, companies created non-wage fringe benefits to attract workers. Company paid sick leave and health insurance became a standard offering. In an odd way, we have Hitler and Hirohito to thank for our current system. Perhaps that was their way of getting even.

So here we are, about to embark on the next great phase of health insurance now promised to all Americans. It was inevitable and only the mechanisms remain to be debated. What are some factors to be considered? Here are a few:

1. The third-party payer system we use insulates us from price information. We have no idea how much a knee replacement is going to cost and little incentive to find out. Yet a study by a large California employer revealed that arthroscopic knee surgery varied from $4,300 to over $26,000 across a number of reputable hospitals. There is no incentive for the patient to shop around and no competitive pressure on the hospitals to rein in prices.

2. Economists have written much on the moral hazards of insurance. These range from arson fires for profit to murder in order to collect life insurance, but also include the overutilization of services simply because one knows that one is insured. It is this overutilization that is most pertinent to our consideration.

3. Community rating rather than risk-based premiums reduces the incentive to avoid risky behavior. For instance, imagine if fire insurance premiums were the same for all regardless of property conditions. The owner of a tumbledown wreck of a building with open fireplaces and candles in every window would pay the same rate as a modern structure built of fire-retardant materials and utilizing the latest in monitoring and fire suppression technology. That doesn’t seem right because it isn’t. But that’s precisely what we’re doing with health insurance.

There is one existing model that directly addresses these issues and has already proven successful. Policymakers should do more to encourage Health Savings Account (HSA) plans. With these, the employee and employer regularly deposit funds in a tax-advantaged account which can be invested and grow over time. The important distinction is that this money is yours – it belongs to you. Medical expenses are paid from this account as they occur. You are highly incented to avoid unnecessary services and to seek out the most favorable pricing. Further, you will optimize healthy habits (diet, nutrition, and exercise) out of enlightened self interest. You are protected from catastrophic expenses by a deductible provision in the policy. 

If a broad swath of Americans used HSA accounts, we would see improved health and, for the first time, downward pressure on medical costs. (HSA plans are allowable under the Affordable Care Act – this would require no new legislation).

As for any plan, there are critics. But this seems a rational place to begin. Assuming, that is, that you view the majority of people as responsible adults, capable of successfully leading their lives as they please. If not, that’s a pretty dismal outlook on your fellow humans.