What we stand to lose: health insurance is different

Health insurance is a potentially confusing subject - Congress certainly seems to be unsure what to do about it. But at its core, it's not that complicated.

It is, however, surprising. Some of the things we think we know from other types of insurance, or even other economic situations, end up pushing in surprising directions when we apply them to the question of health care.

The previous post in this series looked at coverage for homes, cars, and lives, in order to introduce the key concepts for thinking about insurance. They're summarized here:

• Risk pooling: the average outcome for a group of people is far more predictable than the specific outcome for any individual. So when we pool a bunch of people, there's a lot less uncertainty about the average cost associated with that group than about the specific cost associated with any individual in the group. Risk isn't merely transferred by pooling; it's actually reduced.
• The lucky pay for the unlucky: if you never "get" to file a claim on your insurance, it's because nothing bad ever happened to you.
• Mandatory insurance: under certain circumstances, the government or some private entity might require you to buy insurance as a condition of something else.
• Moral hazard: when you are spared from the bad possible outcomes of risky behavior, while benefiting from the good outcomes, you'll take more risks than you should.
• Actuarial fairness: when the premium you pay is proportional to the cost you are likely to represent.
• Adverse selection: when an insurer is unable to make use of information about characteristics of its customers, that affect how costly they're likely to be. The insurer charges higher premiums to protect itself, the less costly people drop away even more, and the pool falls apart.

The weirdness with health insurance starts when we take the concept of actuarial fairness, and ask what happens when we apply it to individuals. That is, what if we figure out the health-insurance premium for each individual that is scaled to the health costs he or she is likely to incur?

It pretty quickly becomes clear that we will have a group of people who are essentially uninsurable.

Let's say you're born with a genetic abnormality. Untreated, you have a diminished lifespan and poor quality of life. With treatment, you expect to have a more or less normal lifespan, and pretty good quality of life. Treatment costs $25,000 per year.

If an insurer is going to cover you and include treatment of your genetic condition, they're going to have to charge a premium of at least $25,000. Applying actuarial fairness to the individual means that you have to charge a premium that you expect will not lose you money. If there's $25,000 of medical costs you are certain to have, the insurer has to start their premium there.

But of course they can't stop there, because you, like anyone else, could get hit by a truck. You could contract an infection. You could develop heart disease, or cancer. All those things are only possibilities, so the insurer only charges a fraction of what those things will cost if they happen, so maybe they add another $10,000 per year. Your premium is $35,000 per year.

Or another person develops diabetes and now has likely annual medical costs of $12,000 (that's probably a conservative figure). Instead of adding $10,000 like in the first case, we're going to add $13,000, because diabetes brings with it heightened risk of numerous other medical problems. So this person's annual premium is $25,000.

Median household income in the U.S. in 2015 was $56,500. In other words, half the households in the U.S. had income above that level - and half had income below it.

If your household income is $55,000, you can't afford an annual premium of $25,000 or $35,000. And that's just one person. If there are two more people in the household and they're healthy, that's another $10,000 or $20,000 in premiums. Completely unworkable.

Here's the first big, difficult thing about health insurance. "Actuarial fairness" sounds good, because it has "fairness" right in its name. But when we apply it to individuals, we create a significant group of "uninsurables."

Many Americans have had the good fortune never to have seen this problem face to face. They get their health insurance through their employer, and their employer does two things.

First, many employers pay some substantial part of your premium. The insurance company might charge $10,000, but you only have $4,000 deducted from your paycheck. Your employer puts in the rest on top of the salary or wage you've agreed on.

Equally important, your employer provides a pool. When you buy insurance through your job, everyone gets a policy at the same price. There might be options, in terms of your copays, etc., but everyone who chooses the same plan, and is getting the same number of adult and child dependents covered, pays the same amount.

In other words, actuarial fairness isn't being applied to you as an individual. If you happen to be an expensive person to insure, the cost of your care gets spread out over the cost of all your colleagues' premiums, rather than being attached directly and solely to you.

So here's the good part of employer-based health insurance. It provides a vehicle for (many) employed people to have affordable premiums, and it allows people with pre-existing conditions to have access to insurance (and thus to treatment for their conditions).

And hopefully, the company doesn't have too many medically expensive employees.

Because while actuarial fairness isn't being applied to you, it is being applied to your employer. If your insurer sees a couple of years where people at your company are racking up higher-than-average medical costs, they'll have to raise the rates they charge everyone.

This issue is more acute for small companies than for large. If a company has 10,000 employees, it's not a big deal if five of them are medically expensive. If there are only 200 employees, then even one medically expensive person is noticeable, and it's a real problem if there are two.

So coverage at small companies is likely to be more expensive. Before the Affordable Care Act, small companies were less likely to offer insurance; now companies with 50 or more employees are required to offer it, though smaller companies can still choose not to.

This is linked to the other shortcoming of using employer-based insurance to deal with the problem of uninsurables. It works if you're employed and if your employer offers insurance, but it leaves out everyone else, and by creating an especially large strain on small companies, it reduces the number of companies that offer it.

In short, employer-based insurance is better than everyone being out there shopping for insurance on their own, but it leaves a big part of the problem unsolved.

The key question is whether we think actuarial fairness should be applied to individuals. If we answer "yes," then we will have large numbers of people who are uninsurable.

If we answer "no, let's not apply actuarial fairness to individuals; let's apply it to pools made up of a company's employees," then we reduce the number of uninsurables, but we still leave a significant number out there, and we make life difficult for employers, especially small ones.

The next post is about how the Affordable Care Act tries to address the problem.