Back to Basics

We will be publishing a series of “Back to Basics” articles to give Members of Congress and others a grounding in some of the principles of health care financing.

INSURANCE VERSUS THIRD-PARTY PAYMENT

By Greg Scandlen

When people discuss “the uninsured” they are not usually speaking of insurance at all, they are talking about third-party payment of health care services. Insurance is a contract between two persons. The contract says that one person will pay a premium so that the other person will pay a benefit when an unfortunate event occurs. This is how life insurance, homeowners insurance, auto insurance and almost all other forms of insurance operate.

So-called “health insurance” has come to be a very different breed of animal. Most health insurance is based on a three-party arrangement in which a person pays a premium to an insurance company, which pays a physician or a hospital to provide a service to the consumer. It is a triangular relationship that causes great confusion and administrative costs, and results in little accountability between the three parties. It also results in excessive utilization as patients are insulated even from knowing the price of the services they consume. Once the premium has been paid, the services are all free or nearly so. There is no economic constraint whatsoever on consumption of services. The only constraint is imposed by the payer through some form of rationing, which is very expensive to enforce and very intrusive on the relationship between patient and provider.

Our near-exclusive reliance on third-party payment to finance health care services has resulted in our health care system being in a state of perpetual crisis as we lurch between panic about cost increases one year, poor quality the next, and inadequate access after that.

The only way to achieve an optimal balance between the competing demands of cost, quality and access is through consumer choice and decision-making about how to spend resources. Expanding our current system of third-party payment will only compound a problem that has proven to be unsolvable in the past.

RISK POOLING VERSUS PRE-PAID HEALTH CARE

Prepayment of health care services (prepaid health care) is also fundamentally different than insurance (pooling risk.) It is a distinction that too often escapes policymakers and too often leads to misguided policies such as community rating, mandated benefits, and other forms of social welfare in the guise of insurance coverage. In discussing risk pools, policymakers tend to put the emphasis on “pool” and not on “risk.” In this view, a health insurance company is a big pool of unrestricted money from which people withdraw funds to pay for the services they need. This thinking leads to a “tragedy of the commons” phenomenon where people try to pull as much as possible out of the pool before it runs dry. It is small wonder that health care costs are out of control.

The emphasis in the expression “risk pooling” should be on “risk,” not on “pool.” The thing that is being pooled is risk. A risk is an uncertainty. If we voluntarily pool our uncertainties, some of us will incur a “loss” (the risk of bad outcomes will be realized), but most of us will not. The risk pool provides all its members with protection against a catastrophe, but we are happier if we never have to collect a benefit.

There is no big unallocated pool of money in this arrangement because every dollar held by the insurance company is already contractually obligated. Because insurance is a two-party contract, the premiums are paid to secure a specific benefit. The insurance company is required to hold enough money in reserve to pay all the benefits it is contractually obligated to pay. Because a risk is an uncertainty, the company does not know who will get the money or when it will be released, but it knows from experience that a certain number of customers will have losses, and it is obligated to pay the contracted amount when the loss occurs.

Prepaid health care is something else entirely. It is not “insurance” because there is no “risk” involved. We may know for example that we are likely to consume $6,000 in care over the next five years, so we pay 60 monthly premiums of $100 because it is more convenient to spread out the cost in equal increments. There is an element of cost sharing involved because a few people may consume only $4,000 while a few others consume $8,000, but at its core the principle is the same – it is a way of financing known consumption.

In that sense, there is no particular advantage to “pre-paying” for health care services over “post-paying” for the same service. That is, as in our example of normal child birth expenses cited above, one can pay in advance $100 a month for five years to get a benefit of $6,000 when the baby is born, or one could have the baby, incur $6,000 in expenses and pay it back at $100/month for five years. Providers prefer pre-payment because it saves them the trouble of having to collect a debt, but there is no fundamental difference in the economics of the transaction.

Yet in counting the uninsured, someone with a pre-paid program is considered insured while someone with a post-payment program is not, even though in both cases the patient has to make 60 equal payments of $100 to cover the $6,000 expense.

One more thing on risk pools – Many people assume that if we are pooling risk, the bigger the pool the better. But, in fact, all of the benefits of risk pooling are achieved with a relatively small number of people. The optimal size of a risk pool is frequently debated among actuaries and depends on a host of factors, (See, for instance, this study of Sonoma County’s Medicaid program) but most of the beneficial effects of pooling can be achieved with as few as 25,000 covered lives. It is simply not the case that bigger pools are better.

People also often argue that one of the advantages of employer-based coverage is “risk pooling,” but a 50-person print shop is far too small for pooling risk. For that matter, so is a 500 person manufacturing company. The employees of these companies are also likely to be similar in age, geographic location, exposure to hazards and infections, income and education. Rather than spreading risk, the employer actually concentrates it. The employer may be more efficient from a marketing perspective, but not from a risk perspective.

In fact, pooling risk is the whole purpose of an insurance company. The insurer may cover hundreds of thousands of people, from many different walks of life and geographic areas.

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7 Responses

  1. If you saw the most recent report on how much someone retiring has paid in compared to how much they will “spend” it is relevant to this article. The numbers were something like $100k paid in and the forecasted amount to be spent on healthcare until mortality was $300k.

    I argue that if the $100k was turned over to the patient to control, the patient would easily be able to negotiate a discount for payment at point of service (eliminate the overhead of insurers inluding medicare)>

    • Excellent point. Such a patient might still spend some of the $100K on a true catastrophic policy with (say) a $20k deductible, but that premium would be cheap, and she would be very careful about how she spent the rest of the dough.
      Greg

      • For “true” insurance, a critical illness plan which pays a lump sum up to $1 million for 21 different illnesses makes a lot of sense, because it’s real insurance not prepaid healthcare. I bought a $250,000 policy when i was 45, and it only costs about $250 a month, and I bought my age. If I never use it, it has a full refund of premium

  2. You’re right, they don’t get it. They GET sound bites and bumper stickers. They hear ringing in their ears from the lobbyists. For years I have been saying that the FIRST thing we need to do is to strike down the entire CPT code system. It is price fixing by CMS which stifles competition among providers, and rewards bad doctors who game they system, and drives good ones out of medicine. Also, outfits like the AMA can easily be bought with the threats of removing the $72 million contract managing CPT codes. ummmm….does thet $72 million dollars add to medical costs?????
    MediBid.com lets doctors set their own rates, and patients decide. We’re having people getting MTI’s for $385 in Minnapolis, and Knee Replacements for $12,000 in NJ.

    Now THAT’s the free market in aciton

  3. “People also often argue that one of the advantages of employer-based coverage is “risk pooling,” but a 50-person print shop is far too small for pooling risk.”

    Absolutely correct. But consider this….High level pooling. If the attachment point of the pooling was on a sliding scale, you’d still have an element of experience rating. Say a 2-5 life group started pooling above $25,000 aggregate, 6-10 lives at $75k, 11-25 at 150 etc, then you’d have some employer skin in the game.

  4. Greg,
    I have not seen a more lucid explanation of this crucial distinction between true insurance and pre-paid care. I’m going to link to this on our website.
    Excellent!

    Richard

  5. Greg,
    This is the most lucid explanation of this crucial difference between insurance and prepaid care that I have seen.
    I’m going to see if we can link to it from AAPS site.
    All the best for the New Year!

    Richard

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