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November 17, 2010

“Mayhem” – How Much of Health Insurance is Insurance?

Filed under: Healthcare — Steve Krupa @ 12:12 pm
Tags: , , , , ,

Do you know Mayhem?

He’s a new character played by Dean Winters in a recent run of pretty-damn-funny Allstate commercials.  Check this one out (< 30 seconds).

You see, before you (the driver) caught sight of the hot babe in the awesome pink headband you needed adequate property and casualty insurance to protect you from the distraction that caused you to drive into that light pole.  However, in the immediate moment after you drove into that light pole, you did not need insurance, because its cost would have been exactly equal to what you really need, which is a new car.  Insurance is valuable to you before you run into Mayhem when its price (the insurance premium) is considerably less than the consequences of Mayhem, or in this case, the cost of a new car.

The cost of insurance is much less than the cost of Mayhem because of pooled risk.  Lots of other easily distracted drivers bought car insurance too but most of them managed to veer away from the light pole at the last-minute, avoiding damage, thus providing you with a pool of funding to buy a replacement car after the accident.  Pooling the risk of low-probability high-cost events makes insurance a very valuable product for all purchasers in their effort to protect themselves against Mayhem.

In the health insurance market Mayhem represents the possibility we might get sick, which we know can be very costly.  Very good drivers can drive into light poles.  Similarly very healthy people can require health insurance to pay for unexpected costly medical procedures.  But either way, the fact that the costs are unexpected makes an event insurable at a price significantly less than the cost of the event.

Someone who is sick and is not insured does not need health insurance; they need to be provided with healthcare.  Including someone who is already sick in an insurance pool is the same as including you in an automobile insurance pool after you drove into the light pole.  The event is no longer unexpected, and so your individual premium, which is the cost of your new car, will be spread among the members of the insurance pool, the economic equivalent of your passing a hat around and collecting enough money to pay for your car – in this instance you are not being insured, you are being subsidized.

A type II diabetic with health insurance that covers the costs associated with diabetes is being both insured for the incidence of diseases other than diabetes and subsidized for the known costs associated with diabetes.

Continuing with our property and casualty analogy, consider flood insurance.  There is a much higher probability of Mayhem occurring at a property located on a riverfront than for a property located on a hilltop miles from the water, and, as such, it costs much more to purchase flood insurance for riverfront property.  I wonder, is this fair?  Would we all stand up for a homeowner’s right to live by the river and insist that the unit price for all property insurance be the same regardless of where the property is located?  If we did the cost to insure waterfront property would reduce and the cost to insure the hilltop property would increase, effectively subsidizing riverfront home ownership.  Now, is that fair?  If we were to subsidize anything shouldn’t we instead subsidize safe behavior, a la, living away from water and well above sea level?

A seemingly healthy person with an unhealthy lifestyle that receives health insurance at the same price as people with healthier lifestyles, as is typical in most Group Health insurance models, is being subsidized for the higher probability of Mayhem.

Insurance markets, left to their own devices, are awesome at pricing risk and incentivizing safe behavior (we all know your premium is going up after you file your auto insurance claim for driving into that light pole).  However they (insurance markets) don’t handle subsidization well at all.  If subsidization is going to be required, then it must be structured by forces outside of the insurance market.

The Group Model of health insurance, which is used in the market for corporate-based insurance, is one such structure.  If you work for a corporation and you are receiving a health insurance benefit from your company, you most likely pay the same per member cost as everyone else at your company.  This is done by pooling both the risks and the subsidies.

Clearly the pooling of subsidies creates fertile ground for Moral Hazard, a phenomenon discussed frequently here, but curiously left out of much of the discussion regarding the problems of health insurance, particularly when the subject is healthcare reform.  Healthcare reform claims to be insurance reform, but in fact insurance is insurance – if you have a pre-existing condition you cannot be insured for it because it is already there (your car has hit the light pole).  At the public policy level “healthcare insurance reform” as it is defined within PPACA, is the regulation of the portion of health insurance that represents subsidies and their funding.

All other things equal, an increase in the probability of Mayhem (more unhealthy people) and the expansion of subsidies into the insurance pool (the insuring of more sick people) will cause proportionate increases in health insurance premiums.  On this basis alone, the provisions of the health reform bill are unquestionably inflationary w/r/t insurance premiums.  Count on it.

As a greater portion of insurance premiums represent subsidy, the role of the health insurer has to change from one of underwriting risk, i.e., pricing the probability of Mayhem, to managing risk, i.e., working to reduce the cost of known conditions within the insurance/subsidy pool, the latter requiring a substantially different set of skills than the former.  This transformation of the health insurance industry was already under way prior to the passage of PPACA (our healthcare reform law), as corporations began requiring risk management programs from their insurance companies.  Without this transformation, healthcare inflation is destined to sustain at its current levels, probably for eternity, or at least until the increases in the prevalence of chronic illnesses and the probability of Mayhem achieve some steady state, which with the baby-boomers now reaching 65 years-old will not occur anytime soon.  Regardless of who “pays” for the insurance/subsidies the costs of healthcare are going up, up, up, until the system shifts toward a structure where patients, payers and providers are economically accountable for managing risk.

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July 6, 2010

Inside Value-Based Healthcare – Part 2: Who Pays for Health(care) Insurance

In my previous post, Value-Based Healthcare Part 1, I talked about the two primary business risks faced by insurers, Moral Hazard and Adverse Selection.  Recall that for health insurance markets to work effectively they must be structured to mitigate Adverse Selection (i.e., the reality that the very fact that someone is seeking insurance might make them uninsurable in the first place).  This means that the healthiest people must stay in the market as part of the risk pool, otherwise the underwriting will not work at affordable premium rates.  As such, employer-based Group Model health insurance has evolved as the prevalent distribution method.

So who pays for employer-based health insurance?

Today health insurance costs average about $4,800 per person per year.  While this expense is paid for by employers, it is essentially part of salary costs, and so it is really money that would otherwise be paid to employees were it not for the mandatory participation required in most Group Model plans.

Employers offer to buy the coverage on behalf of employees because they believe that having their employees insured improves productivity and it is viewed by prospective employees as a competitive perk.  This works out well from a risk pooling perspective, making Group Model insurance less expensive on average.  But what really drives the Group Model is its income tax subsidy.  The federal government does not assess income taxes on the value of Group Model health insurance (this subsidy does not exist for individual purchases of health insurance).

This tax subsidy is massive.  The average employee is in the 25% federal income tax bracket, making the subsidy worth about $1,200 per year (25% of the $4,800 average annual premium).  Approximately 180 million people participate in Group Model plans, meaning the total amount of this annual subsidy is about $216 billion per year.

So who pays for employer-based health insurance?

According to these calculations 180 million employees cost a total of approximately $864 billion, $648 billion is paid for by employees through payroll deductions and about $216 billion is paid for by the federal government through income tax subsidies.  These amounts exclude out-of-pocket expenses, which are by enlarge paid for by employees.

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Let’s get back to Moral Hazard.

Have you ever noticed that people are very hesitant to make claims on their automobile and property insurance?  Rarely do the costs of minor fender benders result in an insurance claim.  Why?  Because people fear that claims on their auto policies will result in either their premium increasing or their policy getting cancelled.  People tend to reserve that type of insurance for major catastrophes, paying the cost of minor accidents out of their own pockets.

Most people do not behave this way when it comes to health insurance.  A very high percentage of healthcare expenses become insurance claims.

Few people lose their insurance because of high insurance claims.  As claims increase, the burden of the higher premium is shared among the risk pool.  As a result, Moral Hazard (changing your ethics because you don’t pay for the consequences of your bad behavior) in Group Model plans is severe, and many believe it contributes significantly to the 8-12% average annual healthcare inflation rate.  Despite the reality that employees pay for more than 75% of the cost of their health insurance, they are fearless when making insurance claims.

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So, returning to the thread that ended Value-Based Healthcare Part 1.

Employer-based health insurance suffers from Moral Hazard.  Despite the fact that it seems obvious that employees pay the most of the tab, the cost is not individualized and the consequences of bad behavior are not perceived as even remotely severe.

Research backs the notion that when an insured party pays a higher percentage of the total cost of the service Moral Hazard reduces.

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption why not just increase the out-of-pocket payments and reduce Moral Hazard?

In some cases higher out-of-pocket costs can lead to Unintended Consequences, namely people forgoing necessary treatment.  For example, the medicines necessary to treat Type-2 diabetes are much less expensive than the costs associated with the side-effects of untreated diabetes like heart attack, stroke, amputations, blindness, etc.  A health insurer wants Type 2 diabetics to take their medications, however high out-of-pocket charges often impose barriers to compliance.

Medications like Glucophage, a treatment for Type 2 diabetes, have a high value.  The treatment costs about $400 per year, real money for an individual, but a small investment for a health insurer given that compliance with the drug should mitigate a number of side effects of Type 2 diabetes, saving money on hospitalizations and other forms of expensive healthcare.  Further, Type 2 diabetics should see podiatrists and ophthalmologists regularly.  Again, high co-pays for these services could mitigate compliance and increase adverse events within an insured diabetic population.

Value-Based Healthcare: Definition #2:

Value-Based Healthcare involves designing insurance benefits with economics that encourage (or remove the barriers to) the utilization of high-value healthcare services.

So why is Value-Based so new?  What are the barriers to implementing Value-Based?

These questions will be covered in future posts.

To leave you with something to think about, it was only until recently that the information technology necessary to begin experimenting with the implementation of Value-Based Healthcare became available.

June 25, 2010

Inside Value-Based Healthcare – Part 1: Moral Hazard

Value-Based Healthcare.  There, I said it…

I had fun on Wednesday sitting on the healthcare reform panel at the Dow Jones Limited Partners Summit.   The conversation centered on investment trends in healthcare as updated for the passage of PPACA, during which I blurted out the concept of value-based healthcare, a pretty complex and to some extent novel concept, and a cornerstone to many of Psilos’ VC investment strategies.  This was subsequently reported, and to Jennifer Rossa’s credit, she provided enough detail around my comment to correctly convey the concept.

There are important nuances, however.  This post is the beginning of a series that will explore the ins-and-outs of Value-Based Healthcare.

Value-Based Healthcare: Definition #1:

Value-Based Healthcare, or more specifically, Value-Based Health Insurance Design, its sobriquet being simply, Value-Based, intends to mitigate the Moral Hazard inherent in low cost-sharing health insurance coverage.

If we were to take an insurance or advanced finance class together we would spend a lot of time talking about Moral Hazard and Adverse Selection, the two primary business risks that underpin managing financial institutions, insurance companies and banks included.  Failure to manage these risks properly can lead to disaster (in fact, recently Moral Hazard and Adverse Selection got the better of the mortgage banking business, a primary cause of the financial crisis).

Moral Hazard reflects the reality that a party insulated from a risk (like an insured or a borrower) will behave differently than if it were fully exposed to the risk.

Adverse Selection reflects the reality that the very nature of a party’s desire to seek insulation from risk reflects a greater risk of loss.  For example, parties that are either sick or expect to get sick have a higher demand for health insurance.  Similarly, parties in the market for a mortgage that have a concern that they may default are more attracted to low-down-payment mortgages.

Underwriting models are designed in part to set prices to countervail the risks of Moral Hazard and Adverse Selection.  This is more easily accomplished in an underwriting model where each policy gets priced individually, like automobile insurance.  In this model individuals are placed in broad price cohorts based on age, gender, style of car, etc., and then adjustments to the policy price are made based on individual attributes like historical driving record.  Moral Hazard and Adverse Selection are less prevalent in insurance markets where policies are individually underwritten and where the underwriter will be the party that ultimately pays the claims on any policy.  Absent these conditions the risks of Moral Hazard and Adverse Selection will always be lurking.

Such is the case in the current market for employer-based health insurance (also called Group Model health insurance).

Let’s start with Moral Hazard.  Today many employer-based health insurance models feature low cost-sharing, meaning that patients pay a very small amount of the health resources they consume.  Here the economic question is whether the value of a healthcare service exceeds the out-of-pocket cost to the patient, which is a small fraction of the actual costs.  Moral Hazard comes into play because the insurance insulates the patient from full payment, thus altering behavior toward increased healthcare consumption, a phenomenon some believe is encouraged by the fact that providers (doctors and hospitals) are generally not at risk either and are paid on a fee-for-service basis.

Consider what might happen if the out-of-pocket costs to the patient were raised.  In insurance markets where patients could opt out and choose not to buy insurance, an increase in out-of-pocket costs would certainly result in some people, probably the healthiest, declining coverage.  This would cause premiums to rise, because the insured pool would be sicker on average, causing more of the healthiest people to decline, increasing the risk of the pool, increasing the premiums, and so on, into an Adverse Selection spiral.

In health insurance markets we need the healthiest people to stay in the market in order for the underwriting to work at reasonable levels of insurance premium.  This is one of the reasons why health insurance is provided by employers.  Employers, or coalitions of employers, are able to deliver large enough populations of sick and healthy people for the underwriting to work.  The participation of large numbers of employees mitigates Adverse Selection and as a result many large employers choose to self-insure (tax incentives is another reason employer-based health insurance dominates – more on this another time).

Nonetheless, in employer-based health insurance we are still left with Moral Hazard, and research seems to back the notion that its degree is inversely correlated with the percentage out-of-pocket paid by patients (low out-of-pocket = high Moral Hazard = high healthcare consumption).

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption (and believe me, we are), why not just increase the out-of-pocket payments and reduce Moral Hazard?

It turns out not to be that simple.  Please give this some thought and we’ll dig a little deeper next time…

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