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ObamaCare & the Meaning of Insurance

e21 | 04/13/2012

The key question surrounding the constitutionality of the Affordable Care Act (a.k.a. ObamaCare) is whether the federal government can compel citizens to purchase health insurance. Absent the mandate, ObamaCare will not function as intended because the program’s coverage guarantee and expansion is financed, in part, through cross-subsidies generated by mandating that individuals purchase insurance policies that cost several times more than their expected insurance claims. Defenders of ObamaCare rationalize these compulsory transfers as inherent to “insurance,” which they erroneously present as a system where low-risk policyholders are expected to overpay for their coverage to reduce the cost of the policies for those with predictably high claims.

During oral arguments, Justice Alito pointed out that the coverage mandate was actually much worse than simply forcing someone to engage in commerce. Since the mandate is aimed at healthy people, it forces people to engage in commerce at hugely disadvantageous terms. Justice Alito cited data that a young healthy individual consumes, on average, $854 in health services each year but would be forced by the law to buy a $5,800 individual policy. To this, Justice Ginsberg responded, echoing a Washington Post editorial, “if you're going to have insurance, that's how insurance works.” But that is not how insurance works; that is how the cross-subsidies designed by the Affordable Care Act work. That is an important distinction.

Insurance always involves transfers between households on an ex post, or after-event basis. Someone’s house burns down, for example, and that person’s insurance claim is effectively financed by the premiums paid by thousands of other households. But this is fundamentally different from ex ante, or pre-event, transfers of resources where someone is forced to pay premiums that are substantially in excess of the discounted present value of his expected insurance claims. Insurance underwriting involves the assessment of risk and the imposition of differentials in premium rates across policyholders to reflect differences in the value of their expected claims.

Defenders of ObamaCare argue the mandate is necessary to “create a broad risk pool” and lower everyone else’s costs. As explained by Professor Kevin Outterson of Boston University, Obamacare is designed to “broadly consolidate health insurance risk pools by prohibiting most underwriting.” This means that instead of differential rates based on expected claims, insurance rates will be set at the average costs of the pool. As a result, “if a healthy person stays out of the pool, the average cost of those left in the pool is higher” because the premium rate is set to average cost (plus underwriting fees and a risk premium). In short, the mandate would not work as intended unless: (1) we know, through basic underwriting, that the expected costs of the people forced into the risk pool by the mandate are lower than the average of the pool; and (2) the new entrants pay premium rates disproportionate to their expected costs. Unless (1) and (2) hold, everyone else’s costs would be left unchanged by the mandate.

Much is made of “risk pools” and “risk pooling” in insurance markets, but these terms are not euphemisms for cross-subsidies. The size of the risk pool matters because the larger it is, the closer actual losses will be to expected losses. It is much more difficult to estimate the average claim of five people in a risk pool than the average claim of 5,000. Large companies pay lower insurance rates partly because the insurer does not have to charge as great a risk premium to account for uncertainty surrounding expected losses. The same is true for car insurance and other independent risks; increasing the size of the risk pool in most insurance markets lowers costs by increasing forecast accuracy and dampening year-to-year variation in insured claims, not by conscripting low-risk policyholders to subsidize everyone else’s rates.

Similarly, “pooling risk” means transferring the risk from an individual to a pool, like a “mutual” insurance company that consists of the accumulated financial resources of the policyholders in the risk pool. Transferring risk to a pool increases efficiency by relieving individual policyholders of the need to generate sufficient liquidity to pay expenses out of pocket. The lack of reliable health and life insurance in China, for example, causes households there to save far more than would otherwise be necessary, which compromises economic efficiency and creates a huge savings-investment imbalance. Pooling risk provides an alternative to the accumulation and maintenance of cash balances and also aids economic efficiency by providing an asset whose payout comes at precisely the time additional resources are most valued by the household.

The concerns about the average cost of the risk pool are quite different from arguments about the cost of “free riders.” The Administration and its supporters routinely mention uncompensated care costs when explaining the need for the mandate. The Administration claims that the cost of uncompensated care is over $110 billion per year, while other estimates suggest that uncompensated care expenses are about half of that and unlikely to exceed $100 billion until 2018. Putting aside the question of scope, however, the real problem is that uncompensated care costs to hospital emergency rooms have no connection to the mandate because the healthy, low-risk people impacted by the mandate are generally not the ones receiving uncompensated care. It is telling that page 43 of the government’s brief makes no mention of uncompensated care when laying out the rationale for the mandate, instead focusing on the need to “broaden the health insurance risk pool to include healthy individuals, which will lower health insurance premiums.” Moreover, the cost of providing care to individuals who currently receive uncompensated care through hospital emergency rooms is likely to increase. The Medicare Actuary estimates that health expenditures will rise by $310 billion due to the greater utilization of health care services by these individuals and other newly insured (i.e. the other parts of the uninsured population that don’t have insurance today but would under ObamaCare).

It is telling that the most recent experience with “that’s how insurance works” rhetoric came in 2006 when Gulf Coast lawmakers tried to drum up support for the idea of “pooling” hurricane risk, through a federal insurance program that would include non-coastal states in the “risk pool” and thereby lower average rates. At that time, the unique feature of that insurance market was the covariance of the claims of policyholders, whereas this time it is the adverse selection of the health insurance market. But one way to address the adverse selection problem is to expand association health plans and private mutual health insurance by eliminating restrictions on what entities can offer insurance and who is eligible to buy it. Some of these proposals were ridiculed by the Obama Administration because the government could not dictate the terms and conditions of the coverage offered by these private risk pools.

The obvious implication of the “that’s how insurance works” rhetoric is that the critics of the law simply don’t understand insurance, otherwise they’d realize how illogical many of their claims really are. Insurance is not predicated on mandates, cross-subsidies, and coercion. The mandate may be necessary to effectuate the cross-subsidies at the heart of Obamacare, but these cross-subsidies are not an essential feature of insurance. Perhaps it is not surprising for “insurance” to be so misused by Obamacare’s defenders, as the insurance policies required under the program could scarcely be classified as “insurance” in the first place. The mandated coverage of routine expenses like birth control is fundamentally different from insurance’s role as financial protection from extreme loss. Whatever the outcome of the case before the Supreme Court, the public’s understanding of what is meant by “insurance” has been badly damaged by the misleading rhetoric of ObamaCare’s defenders.