Why is Health Insurance so Expensive

Insurance companies are often reviled for the high price of their premiums, but while the charges consumers pay are excessive operating costs for insurers are soaring too. Much as the consumer can feel trapped by health care charges insurance companies fret about not being able to effectively control business costs. We have seen in our lifetime how firms that do not have great flexibility regarding their costs of business, think of airlines with their fuel dependency, seem destined to struggle. Let’s keep playing devil’s advocate and examine a simple model of how insurance is priced.

Let’s consider an office that has ten people in it with insurance; premiums are 60 dollars per year, per person for single coverage at a group rate. Person A is robust and will use health services that cost the insurance company only 10$ a year, person will use 20$, person C will use 30$ and so on. The first formula shows what the insurance company would make off of that office when everyone opts into the purchase; the second represents the insurance company’s profits when people make intelligent choices (Person A-D would opt out of purchasing insurance because they’re better off paying out of pocket).

600 – (10+20+30+40+50+60+70+80+90+100) = 50. So the insurance company charged everyone the same price and made a profit of 50$ out of out 600$ before costs. It is clear that the company that sells insurance is incurring risk for very little chance of profit. To protect those people who truly do need health care it must come up with a way to stay in business. Unfortunately, in order to protect the health of persons F, G, and H (60$, 70$, and 80$) the insurance company must come up with a pretext to deny persons I and J (90$ and 100$).

So let’s say the insurance company denies the two most expensive consumers, only granting coverage to 80% of people. Here is how it looks. 600- (10+20+30+40+50+60+70+80) = 240$. So the insurance company is a viable business model now after denying the two neediest customers; profits went up by almost 500% and that money can protect customers F and G although they cause the firm a small loss. Interestingly enough the entire pool, besides those who were exiled, will probably benefit since the insurance company will be able to lower their premiums.

Adverse selection: This means that those who are the most likely to purchase insurance will be those who will have the greatest need, and thus the greatest costs. If you knew you had a reasonable chance of needing no insurance you would not choose to purchase it. In other words money from people who do not use the insurance that they pay for goes to help those who use it a lot. The entire operation depends on people opting in who do not use all of the money they contribute in premiums.

Moral hazard: This is the reason why copays exist. The co-pay is instituted to ensure that no one overtaxes the common pool. The downside to a copay is that it drives the poor away from preventive care and towards the emergency room. In the aggregate this actually increases health care costs. This can best be understood as the tragedy of the commons; if everyone can feed their sheep for free on public land each herder will have an incentive let his herd overgraze. When everyone maximizes individual profit from the commons than soon no grass will be left at all.