Why Health Insurance Systems are Mismanaged

Incentives are Misaligned

Whenever someone else pays for something, the incentives are misaligned. This is true of health insurance. It is certainly true of government-provided health insurance. In an email, John C. Goodman reminded me,

In a typical health insurance pool, 5% of the members will account for 50% of the costs. If you are the Minister of Health, you cannot afford (politically) to spend half your budget on 5% of the voters – many of whom are too sick to even go vote.

The result, he argues, is that relatively healthy people receive benefits (free annual checkups!) but people with expensive illnesses find that services are rationed. I think that is also true to some extent with employer-provided health insurance. The incentive is to make all employees feel like they are getting something.

If people pay for their own health insurance, the market is subject to selection games. The individuals with the most incentive to buy health insurance are those that will cost the insurance company the most in claims. (Although it turns out that there is a selection effect that goes in the other direction. People who are high in conscientiousness are more likely both to obtain health insurance and to take better care of themselves.) Insurance companies, by the same token, have an incentive to try to avoid writing policies for people who most need health insurance. Nobel Laureate Joseph Stiglitz was known for pointing out that this selection game might have no viable solution: the health insurance market could collapse entirely.

To avoid selection games, the government can try to set up artificial pools of people, with insurers competing to serve a pool. This was the idea behind Hillary Clinton’s highly technocratic and poorly received health care ideas during her husband’s Presidency.

Another challenge with health insurance is the conflict between insurers and health care providers. The incentive of the health care provider is to propose the treatment that has the highest profit margin, even to the point of fraudulent billing. The incentive of the insurance company is to approve the treatment that has the lowest cost and to spend resources trying to police fraud. The patient is caught in the middle. Because you are not paying for the treatment yourself, you may have to defer to the decision of the insurance company, and you (or whoever is paying for your insurance) has to cover the insurance company’s overhead.

One idea is to integrate health insurance with health care, as is the case in a Health Maintenance Organization. In theory, the HMO has an incentive to choose the most cost-effective treatment.

But HMOs do not solve every incentive problem. How is the HMO to be compensated? If it is reimbursed for procedures, then the incentive to up-charge remains. But if it is reimbursed on a flat amount per person enrolled, then it has an incentive to select only healthy people.

Indeed, when it comes to compensating health care providers, there are economists who do not think that any existing methods can work. They instead advocate “pay for quality.” That is, a bureaucrat will look over the doctor’s shoulder and pay more to doctors who order procedures that the bureaucrat deems cost-effective. I think that this is about as likely to work as a government program to determine the compensation of middle managers in corporate America by looking over their shoulders and judging their management techniques. The Obama Administration had some “pay for quality” advocates who were influential, but their proposals became characterized as “death panels” by opponents, who neutered the idea.

The issue of whether individuals should be making health care choices is subject to debate. Of course, the example of a patient who is brought unconscious to the emergency room is one in which the patient will not be making the choice. But most health care spending is for procedures in which the patient is in a condition to make decisions.

One argument is that patients do not understand enough to make good decisions concerning health care. But many consumer decisions are made without complete information. How do I know how to choose a computer or a used car? As consumers, we make mistakes all the time. That does not necessarily mean that if government made the choices for us it would always be right.

Another argument is that consumers are myopic. They make health care decisions that are easy in the short run but costly in the long run.

There is no perfect system. In Crisis of Abundance, I proposed a system that would greatly increase the share of medical services that people pay for themselves. They would only be insured against expenses that are very high relative to their ability to pay for them. I call this providing insurance only for the very poor and/or the very sick.

But with the possible exception of Singapore, nowhere do we observe a health care system where most of the responsibility for paying for health care falls on the individual. My proposals make sense to me, but they will never be popular.

This essay is part of a series on human interdependence.