Talk to Me Like I'm 4: Why Our Health Care System Failed Us and How We Can Fix It

By J. Goodrich, AlterNet. Posted February 12, 2009.

Now, where did these intermediaries come from? The market for tomatoes has no tomato insurance, no third-party funding and no employer assistance, because we don't suddenly wake up one morning to find we need tomatoes that day to stay alive, and because buying tomatoes is not especially expensive.

Some health care needs, however, are both sudden, hard to predict and disastrous if not attended to. Many of those are also very expensive. Hence, the need for medical insurance, a system where we hope to convert a large uncertain future loss of money into a smaller regular payment to the insurer so that we don't have to try to save huge amounts of money to cover possible future medical expenses. We can sleep better with insurance, too.

Insurers, if for-profit firms, can earn a profit out of this in a manner familiar to us from car insurance. Sounds very nice, doesn't it? But the presence of medical insurance introduces a few new problems for the traditional view of competition as a Good Thing -- moral hazard and combating adverse selection.

These odd terms are what I call free ice cream and cherry-picking. Moral hazard (or free ice cream) is a term the insurance literature uses to describe the fact that the very act of being insured can change people's behavior. As an example, if I insure an old warehouse against fire, I might then have an incentive to burn the place down when my business is doing poorly.

In health insurance, moral hazard usually refers to the fact that an insured patient doesn't have to worry about the actual costs of the treatment but only its out-of-pocket price. (Imagine how you might act in a farmers market if your purchases there were covered by insurance!) It's like free ice cream, if you happen to have the kind of insurance where you pay nothing for a particular service.

But the ice cream is not really free. If all insured individuals consume more than they would without insurance, the price of insurance (or its premium) will ultimately rise. The higher that price goes, the fewer people can afford insurance.

Free-market acolytes often worry about this. Their usual recommendation is to make consumers more sensitive to the real prices of medical care by increasing that out-of-pocket price. But this brings us back to a world with less real insurance at the time of need, more worry about the future and the whole question about our ability to judge prices and quality in health care. Well, that is the world in which we already live; one with only partial insurance.

Not only do most of us have to pay a sizable out-of-pocket cost (in deductibles and co-insurance rates), but we may also find that the claims we thought would be covered are not. To go further in that direction is not much different from making insurance unavailable via too-high premiums.

Of course, that, too, is the world many of us inhabit: No insurance at all, or none through firms that operate in the market place. Government programs such as Medicare (for the elderly), Medicaid (for certain groups of the poor) and VA health care program (for the veterans) take care of the insurance needs of many but still leave between 40 million and 50 million Americans uninsured. That is not exactly universal coverage.

So much for the ice cream metaphor. In hindsight, it's not the best possible one because it conveys something frivolous. Perhaps I should have called my metaphor "free cod liver oil?"

In any case, there's ultimately no free health care, of course, just as there's ultimately no free ice cream (or cod liver oil), and any health care system must grapple with the problems of how to keep costs down while maintaining access and a reasonable quality of care.

Private health insurance markets have an extra problem with guaranteeing access to health care. That is how to avoid the "barrel" of the insured consisting mostly of "bad apples," those who are going to use a lot of health care and thus cost a lot to the insurer.

Suppose a health insurance policy is offered to all applicants at the same price, something reflecting the average health care expenses of a community, plus a little extra for the firm's expenses and profit. Such a policy would look great to individuals who have very high health care needs but pretty bad to individuals who expect not to spend very much on health care.

As a consequence, the policy would probably attract more high-users than low-users, and its price in the following year would have to go up to reflect the higher claims experience. This would make the policy even less attractive for the low-users, more of them would drop out, and the policy would continue to rise in price. Notice how fewer and fewer individuals end up covered here and how the price of insurance keeps on rising?

This scenario is an extreme case of something called adverse selection in the insurance literature. It is yet another example of lack of information in the medical marketplace, but this time, it is the sellers who lack the information needed to determine which applicants might be high-users and which low-users.

In reality, that information is not wholly lacking. For example, young people are less likely to be high-users than older people, and anyone with a chronic illness is apt to be a high-user. The insurers can also comb through the applicants in individual health insurance markets in order to find other indicators that might label them as possible high-users. And, of course, they may have the right to offer policies to different individuals at different prices, or to exclude certain services from coverage altogether.

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J. Goodrich is an economist. Her writing has been published in the American Prospect, Ms. Magazine and on various political Web sites. She also blogs at Echidne of the Snakes.

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