Wednesday, April 27, 2011

Econ 101: Why Health Insurance Regulation is a Bad Idea

The AP reported yesterday that the California Assembly's Health Committee has put off a decision on AB52, a bill from Mike Feuer (D-Los Angeles) that would give the state's insurance regulators considerable new powers, most notably the power to reject rate increases it deems "excessive". We suppose this is good news for the moment: any day without this piece of crap in force is good day. But just for fun, let's take a closer look at insurance rate regulation.

And so is actuarial science!
According to the Democrats on the Committee, the regulation is needed because the rates set by many private health insurers in California are "too high". This suggests an obvious follow-up question: how is "too high" defined? In a free market, the answer would be straightforward. Health plan actuaries would take data on the characteristics of their members (things like age, gender, diagnosed illnesses, and so on), and use the plan's claims history to estimate the expected costs of paying for members' health care. After accounting for patient cost-sharing (deductibles, co-pays, etc.), the "correct" premium would be the plan's expenses divided by the number of members. This would be the lowest premium the plan could offer while still providing insurance and remaining solvent. Would everyone be happy with this rate? Of course not, and they would be free to find an insurer who could give them a better price.

We can already hear your objections. "Come on, GSL," you're saying, "These health insurance companies make huge profits. They could drop their premiums if they took less profit." First of all, that isn't entirely true. But whether a health plan turns a profit from year to year isn't really the question. Remember how those actuaries estimate the plan's health care expenses? Those kinds of analyses carry a lot of uncertainty. And not just the statistical, "our standard errors sure are big" kind of uncertainty. Actuarial work in health insurance is fraught with what Donald Rumsfeld would call "known unknowns". You know that some of your members are going to leave the plan during the year, and other people are going to join up, but you don't know how many of each you'll get. You know that some of your members are going to develop serious illnesses they haven't had before, but you don't know how many or what illnesses. You know that any increase in plan premiums could cause some young, healthy members to jump ship and do without insurance, but you don't know how many. You know that the costs of drugs, materials, and medical devices will increase at a rate greater than inflation, but you don't know what that rate will be. You know that new treatments will become available and that some of your members and contracting physicians will want them, but you don't know how much they'll cost. And you know that the federal government may pass a sweeping health care law, but you don't know what it'll cost the plan to comply with the new regulations. All these things aren't just unknown, they're unknowable; so it's not a question of hiring the best actuaries and firing the bad ones. The point of all this is to emphasize that actuarial forecasts of the plan's expenses could be wildly wrong. Granted, a plan could have luck on its side, gain more members than it loses, keep its costs under control, and see a huge profit. But it's more likely that incorrect guesses regarding many of these unknowns will lead to losses.

"So what?" you might say. "Sure, they take losses sometimes, but why not pass the profits on to customers whenever they have a good year?" Here are three arguments to consider. One, like it or not, shareholder equity is a big part of how health insurers survive bad years. If you take away their ability to earn profits, their stock won't be worth anything to an investor, and having omniscient actuaries will become essential to staying in business. Two, insurers do have to compete with one another, so if one is taking "excessive profits", doesn't that mean a competitor could offer the same level of benefits to its members at a lower cost? In other words, doesn't competition imply that the market would punish excessive profits without any rate regulation? And three, what's so bad about a health insurer earning a profit? Think about it: when someone sells you health insurance, they basically say, "We're going to let you buy something you want with someone else's money, and if you spend more than we anticipate, the loss is on us". Um, if someone's offering us that deal we're taking it, and if they can turn a buck that way, more power to them. But more importantly, if someone's providing you with something you value, they have a right to earn a profit from doing it.

Of course, we expect AB52 will ultimately become law, and that regulators will start rejecting rate increases. Then what? The insurers will respond to the law, probably by increasing patient cost-sharing (e.g., higher deductibles, co-pays, and co-insurance rates), cutting payments to doctors and hospitals, cutting benefit offerings, or closing up shop in California. Or possibly all of the above, and in that order. The politicians and regulators will be unaffected, but everyone else, including the patients, the doctors, the hospitals, the insurers, and the thousands of Californians who work for hospitals and insurers, will get screwed. All in all, just another Tuesday at the office in Sacramento.


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