Why Health Insurance is Doomed to Fail

The health insurance market, currently in dire straits, has a forecast that isn’t very favorable. For starters, health insurance resembles traditional insurance only slightly, but all the holes, gaps and traps make it self-defeating. Health insurance is inherently adversely selective, full of moral hazard and pays for things that “insurance” isn’t designed to cover. All these characteristics lead to market failure and a host of other problems.

Traditional insurance is meant to protect individuals (or corporations) from catastrophic or severe financial disaster resulting from accidental or unforeseen losses. For a single individual to “insure” themselves, the cost of assuming that risk is so astronomical that only a few can afford it. The Law of Large Numbers, a mathematical and guiding principle of insurance, teaches us that a large pool of individuals is needed for an optimal market. However, when an individual can opt out of purchasing health insurance, the market suffers. In that scenario, the spread of risk becomes concentrated among fewer participants causing premiums to increase. Also, the participants who choose to stay frequently “utilize” the system because it’s cheaper than assuming the full cost themselves. That’s adverse selection. The new healthcare law aims to deter the free flow of market departure, but the effectiveness will depend on whether the constraints are strong enough.

In its current structure, health insurance, for those who have it, does provide for protections against catastrophic losses. Within that framework, it also provides coverage for catastrophic losses caused or mitigated by individual negligence. This contributes to market failure. When insurance covers losses resulting from individual negligence, and sometimes intentional behavior, with no apparent consequences, the insured (patient) will continue to incur these losses. This is regardless of whether they are aware of the behavior or not. Insurance should cover fortuitous or accidental losses. Trauma related losses such as car accident injuries and broken bones from sports can be considered more conventional catastrophic losses that health insurance should look to cover. Bariatric surgery or heart bypass surgery needed subsequent to a life full of poor eating habits and a lack of exercise are losses incurred due to negligence. Without a market mechanism to recognize these and other behaviors as high risk or uninsurable, the health insurance market will suffer. The new health care law may exacerbate this problem by removing lifetime coverage limits for individuals and setting a fixed range for premium for certain classes of individuals.

As stated before, insurance is traditionally for catastrophic issues. Health insurance routinely covers claims for services and “losses” that are not catastrophic. Should a yearly physical be considered a “loss.” Is there an over-utilization of these types of services because they are covered? And if individuals were to pay the true costs, would the utilization decrease? Would consumers see these costs as too high, driving demand down? Would suppliers (physicians) see this as a reason to lower prices? Without these preventive and maintenance services, would the risk of catastrophic losses then increase due to individual negligence? A look at the behavior of individuals with health savings accounts (HSA’s) or high deductible plans may offer some insight. With increased financial responsibility, would consumers become more aware of their own negligence or vice versa? Answering these questions proves difficult due to the volatility of public and political opinions regarding health insurance.

I am no healthcare economist, but the health insurance market has far to go before becoming pareto optimal.