Health Care Economics

With President Obama pledging to reform the U.S. health care system this year, Smeal’s Keith Crocker, William Elliott Chaired Professor of Insurance and Risk Management, answers some questions about the current system, examines reform options, and looks at the president’s plan from an economist’s perspective.

Why is health insurance tied to employment in the United States?

What we typically hear is that health insurance is a deductible business expense for firms, so it’s less expensive to have employers pay for insurance than having to pay for it individually because firms pay for it out of pre-tax dollars. That’s the argument that gets presented. This portrays employer-sponsored health insurance as an aberration; a distortion caused by a particular set of tax laws that makes it financially advantageous for firms to provide health insurance. This is undoubtedly true to some extent but it’s not the whole story.

Employer-sponsored health insurance helps insurance companies avoid something that’s known as adverse selection, which refers to the fact that when people buy insurance they know more about their risk than the insurance company does. The reason why an insurance company likes to underwrite an employer pool is that those pools tend to be stable. You have a group of people that is pooled together because of their employment. These individuals are not buying insurance because they’re unhealthy; they’re buying insurance whether they’re healthy or not because they’re employed with their firm. So insurers get a stable pool that can underwritten.

I had a paper published in the RAND Journal of Economics in 2004 that looks at this very issue. The paper classifies employer pools by the ease with which people could leave and get jobs elsewhere, which was an indication of the stability of the pool. If people can’t leave, then the pool is completely stable. If folks can leave at the drop of a hat because they don’t think they’re getting a good insurance deal with this pool, they’ll go work for somebody else. We found that the quality of the insurance being offered was critically tied to the stability of the pool. This indicates that one of the reasons that we have employer-sponsored health insurance is that the employer pool of customers is stable and allows the insurance companies to effectively underwrite those pools. Voluntary pools do not work that way.

What is causing health care costs to skyrocket?

To put it in practical terms, suppose we ran grocery stores the way we run our health insurance industry. If we structured the grocery market the way health insurance worked, you would pay a monthly premium to the supermarket. Once you paid the premium, you would have the right, for a $10 co-pay, to go to the supermarket and fill up your cart with whatever you wanted and take it out for free. You would ultimately end up overconsuming and the cost to the grocer would be much higher. So the premium the supermarket would have to charge for your groceries would have to be very high because it would have to reflect the fact that when you consume groceries you are not constrained at all.

In terms of health care, the reason costs seem to be out of control is the incentive system we currently have in place, which gives consumers absolutely no incentive to economize on what they consume. As far as they see it, it’s a free good as soon as they walk into the doctor’s office. At the end of the day, that’s the problem.

What are some ways to reduce health care costs?

The only way to reduce health care expenditures is to reduce the utilization of services, and to do that, there are two options: We can either get people to voluntarily choose less or we can put a structure in place that withholds treatment using rationing, administrative rules, or something like that.
As an economist, I believe in markets and I believe in consumer sovereignty; that is, consumers are the best judge of what’s in their best interest. I think the best way to solve a problem like this is to have well-educated consumers guarding their own pocketbooks. The other option is a public plan that has government employees telling us what services we can and cannot utilize.

Can you explain the president’s plan for a public insurance option?

What the president wants to do is to have a public option, not unlike Medicare, to compete with private insurance companies. The idea being that this would be, in some cases, the insurer of last resort for folks who couldn’t get private health insurance.

Can you explain some other options for health care reform?

One of the options going forward would be something like health reimbursement accounts or health savings accounts. These options put the consumer in the position of having to recognize that the cost of his/her health care decisions ultimately will be borne, at least in part, by themselves. Consumers are then incentivized to make educated decisions about their health care.

I do think that the best option going forward from an economic and an incentive perspective is to seriously think about how we can incentivize consumers. I’m not saying that the current health savings account legislation is what we should have or that it’s exactly the way it should be done. However, to the extent that the health savings account legislation that we do have attempts to incentivize consumers to make cost-benefit decisions in their health care choices, that’s the right idea.

Would a government insurance plan dismantle employer coverage, as the insurance industry claims?

Private insurers are forced to, at a minimum, break even. They can’t afford to lose money promiscuously. A public insurance company, on the other hand, faces no such constraints. Look at Medicare, which is hemorrhaging money in terms of its future liabilities. In an attempt to reduce these future liabilities, Medicare is reducing the reimbursements rates that it pays to hospitals and doctors for providing services.

The problem with this approach is that a big chunk of health care expenses are fixed costs, and if Medicare, or this new public insurance option, chisels down what it’s going to pay doctors, somebody else has to pay those costs. They end up getting pushed onto private insurance companies, which will see their rates have to go up as a consequence, making them eventually unable to compete with the public option.

In a nutshell, forced under-reimbursements from the public option will cause health care providers to look for remuneration elsewhere, forcing them to charge higher rates to private insurance companies, and ultimately driving these private insurers out of the market. That’s the fear, and given what’s happened with Medicare reimbursements over the last decade or so, it is a legitimate one. If there’s a government plan that doesn’t have to break even, it’s going to ultimately torpedo private insurance coverage.

How do you think the president’s plan will affect businesses?

The one aspect of the president’s plan that has raised hackles in the business world is the pay-or-play aspect, in which the government will require employers to provide health insurance or pay a fine if they don’t. Speaking purely as an economist, the problem with that is businesses don’t like it because it increases their cost. When you require that employers provide health insurance, it increases the cost of hiring people and that means employers will hire fewer people. There will be some people who will be unemployed as a consequence of this mandate.

On the other hand, those workers who are hired that didn’t have insurance before will be better off because they will have it. At the end of the day, the strength of the opposing effects needs to be decided. How many people will get insurance who otherwise wouldn’t have it with this mandate versus how many people are now unemployed as a consequence of this mandate? I think the interesting part of the debate will be the discussion over those tradeoffs. I don’t have the answer but I think that’s the ground upon which this debate should be fought. 

Keith Crocker, William Elliott Chaired Professor of Insurance and Risk Management, joined the Smeal faculty in 2003. He previously served as Waldo O. Hildebrand Professor of Risk Management and Insurance and Professor of Business Economics and Public Policy, at the University of Michigan Business School. In addition to his research in the health insurance field, Crocker focuses his research efforts on contracting issues, with a particular emphasis on the role of transaction costs, adverse selection, and moral hazard in the design of agreements. He holds a bachelor’s degree in Mathematics and Economics from Washington and Lee University, and a master’s degree and Ph.D. in Economics from Carnegie Mellon University.