[Joint House and Senate Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
S. Hrg. 108-766
``EXPANDING CONSUMER CHOICE AND
ADDRESSING `ADVERSE SELECTION' CONCERNS
IN HEALTH INSURANCE''
=======================================================================
HEARING
before the
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 22, 2004
__________
Printed for the use of the Joint Economic Committee
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JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
SENATE HOUSE OF REPRESENTATIVES
Robert F. Bennett, Utah, Chairman Jim Saxton, New Jersey, Vice
Sam Brownback, Kansas Chairman
Jeff Sessions, Alabama Paul Ryan, Wisconsin
John Sununu, New Hampshire Jennifer Dunn, Washington
Lamar Alexander, Tennessee Phil English, Pennsylvania
Susan Collins, Maine Ron Paul, Texas
Jack Reed, Rhode Island Pete Stark, California
Edward M. Kennedy, Massachusetts Carolyn B. Maloney, New York
Paul S. Sarbanes, Maryland Melvin L. Watt, North Carolina
Jeff Bingaman, New Mexico Baron P. Hill, Indiana
Paul A. Yost, Executive Director
Wendell Primus, Minority Staff Director
C O N T E N T S
Opening Statement of Members
Senator Robert F. Bennett, Chairman, U.S. Senator from Utah...... 1
Representative Paul Ryan, U.S. Representative from Wisconsin..... 3
Senator Jack Reed, U.S. Senator from Rhode Island................ 14
Witnesses
Statement of Mark V. Pauly, Ph.D., Professor of Health Care
Systems, Insurance and Risk Management, and Business and Public
Policy in the Wharton School, and Professor of Economics in the
College of Arts and Sciences, University of Pennsylvania,
Philadelphia, PA............................................... 5
Statement of James H. Cardon, Ph.D., Associate Professor of
Economics, Department of Economics, Brigham Young University,
Provo, Utah.................................................... 8
Statement of Jeffrey M. Closs, President and CEO, BENU, Inc., San
Mateo, CA...................................................... 10
Statement of Linda J. Blumberg, Ph.D., Senior Research Associate,
The Urban Institute, Washington, DC............................ 12
Submissions for the Record
Prepared statement of Senator Robert F. Bennett.................. 29
Prepared statement of Senator Jack Reed.......................... 30
Prepared statement of Mark V. Pauly, Ph.D., Professor of Health
Care Systems, Insurance and Risk Management, and Business and
Public Policy in the Wharton School, and Professor of Economics
in the College of Arts and Sciences, University of Pennsylvania 30
Prepared statement of James H. Cardon, Ph.D., Associate Professor
of Economics, Department of Economics, Brigham Young University 39
Prepared statement of Jeffrey M. Closs, President and CEO, BENU,
Inc............................................................ 42
Prepared statement of Linda J. Blumberg, Ph.D., Senior Research
Associate, The Urban Institute................................. 49
``EXPANDING CONSUMER CHOICE AND
ADDRESSING `ADVERSE SELECTION'
CONCERNS IN HEALTH INSURANCE''
----------
WEDNESDAY, SEPTEMBER 22, 2004
Congress of the United States,
Joint Economic Committee,
Washington, DC
The Committee met at 10 a.m. in room 628 of the Dirksen
Senate Office Building, the Honorable Robert F. Bennett,
chairman of the Joint Economic Committee, presiding.
Senators present: Senators Bennett and Reed.
Representatives present: Representative Ryan.
Staff present: Tom Miller, Leah Uhlmann, Nancy Marano, Mike
Ashton, Colleen Healy, Wendell Primus, John McInerney.
OPENING STATEMENT OF SENATOR ROBERT F. BENNETT, CHAIRMAN, U.S.
SENATOR FROM UTAH
Chairman Bennett. The Committee will come to order. I
welcome you all to our hearing on Consumer Choice in Health
Insurance.
The whole issue of health care, what to do with it, how to
pay for it, where to take it in the future, seems to be front
and center in the Presidential debate, so I think it is
appropriate that we continue our series of hearings on the
whole health care issue.
As those who have followed this Committee will know, we are
not attempting to try to fashion any particular health care
solution at the moment. What we're attempting to do is to lay
out a record of the various challenges with respect to health
care, with an attitude of a clean sheet of paper, that is, not
what do we need to do to fix the present system, but what
should we do, if we were starting from scratch, had no
constraints, and could create an ideal system? What components
should that ideal system really have?
That's been the overarching attitude of this Committee
since we started this series of hearings, and I think we are
well prepared with a variety of witnesses today, to continue to
look at it in that fashion.
Now, many consumers would like to have greater choice and
control of their health care and health insurance coverage.
They know, from their experience with other types of goods and
services, that choice and competition that matches their
different tastes and preferences end up providing the best
value and the greatest opportunity of choice.
Well, recent efforts to increase consumer choice in health
care have included: Providing multiple health plan options with
employer-sponsored coverage, and that's the kind of thing we
see in the Government program; offering new consumer-driven
health care arrangements such as Health Savings Accounts--now,
we're seeing some experimentation with that now--reforming
Medicare financing to strengthen private plan alternatives.
That was originally called Medicare Plus Choice, back in 1997,
but the name was changed to Medicare Advantage in last year's
Medicare Modernization Act.
Then there is trying to level the playing field for those
purchasers who select individual insurance market products,
rather than employer group insurance coverage, trying to make
that option less expensive.
Well, some of these initiatives have advanced further than
the others, and, in part, that's because various plans to
increase consumer choice in health insurance often face
criticism that they will trigger a host of purported dangers.
The one we hear the most about is called adverse selection.
That term tends to be loosely defined, but widely used, in
health care debates. Its most accurate definition is when
consumers know significant private information about their
expected expenses that insurers do not know.
The assumption is that insurance buyers who know that their
risks are greater than average will want to purchase more
insurance than that which is based on average risk. You know
you're going to be sicker than the company knows, you're going
to want to buy more coverage than the company otherwise would
sell you, in order to take advantage of your increased
knowledge. That's adverse selection.
Buyers who expect their risk to be lower than average, will
prefer less insurance coverage.
Now, this simple description of adverse selection projects
that insurance premiums for the original coverage offered will
increase more than otherwise, because low risks either switch
to other types of insurance, or, in the extreme, drop coverage
altogether. The end result is presumed to trigger a death
spiral of rising claims costs and fewer paying customers to
finance them, under the initial insurance policy, and, in the
worst case scenario, the death spiral extends to the overall
health insurance market, which can break down completely.
With today's hearing, we hope to examine that conclusion to
see how valid it really is. It's important, because those who
believe that more consumer choice in health insurance is just
another risky scheme will attempt to handicap it, if not
prohibit it altogether, through such policy measures as
community ratings, standardized benefits, coverage mandates,
and preferential subsidies.
Today's hearing will examine whether or not employers and
insurers can offer better choices to consumers in practice,
without producing the sort of adverse consequences that I have
just described in theory.
We want to determine what really happens in insurance
markets, in the pooling and pricing of risks, and sort out real
problems from imagined ones. It appears that there are natural
limits on the scope and scale of potential adverse selection
problems.
Employers and insurers seem to manage remaining ones rather
effectively in most cases. Nevertheless, there may be policy
opportunities to improve access to the care and coverage that
consumers value the most.
Now, health insurance coverage, of course, as we have tried
to stress over and over through these hearings, is just a means
to an end. The real objective should be better health. Better
health means, ultimately, lower acute care costs.
We also, of course, want better outcomes from medical
treatment when the acute care is necessary, but improving the
value of insurance that's available to a diverse population of
consumers, is, of course, an important part of that process.
Increasing choices, rather than reducing them, seems to be a
fundamental starting point for upgrading the status quo.
[The prepared statement of Senator Bennett appears in the
Submissions for the Record on page 29]
Chairman Bennett. Now, we usually limit opening statements
to the Chairman and the Ranking Member. Mr. Stark is unable to
be with us this morning, and Mr. Ryan has come over, and since
we want to be ecumenical about Senate and House--this is, after
all, a Joint Committee--why, we will allow Mr. Ryan to speak on
behalf of the House in Mr. Stark's absence. That might send
such a chill down Mr. Stark's spine that he'll rearrange his
schedule to be here next time. I do not in any sense mean to
criticize his absence. I know he has a very pressing conflict
this morning, and we will miss him, because Mr. Stark adds a
flavor to these hearings that is very valuable. Mr. Ryan,
you're speaking for the People's House.
OPENING STATEMENT OF REPRESENTATIVE PAUL RYAN,
U.S. REPRESENTATIVE FROM WISCONSIN
Representative Ryan. And for Mr. Stark.
[Laughter.]
Chairman Bennett. I wouldn't go that far.
Representative Ryan. I'll be brief, and thank you very
much, Chairman, for your indulgence. I actually enjoy my other
Committee--Ways and Means--with Mr. Stark, where we have had
great conversations about this.
I'll be very brief. This is a very timely hearing. The
whole adverse selection issue is really coming back up because
we now have Health Savings Accounts [HSA] that are coming out
in the marketplace.
We've had two amendments in the House, just in the past
week, trying to prejudge this issue before any data comes out,
as the Federal Employee Health Benefit Plan is now opening up
its open season to a new HSA product. Those amendments were
defeated, but, nevertheless, there are many who already want to
make the conclusions that HSAs or consumer-directed plans
encourage adverse selection.
I would argue that it's just too soon to tell, but the
early data we're seeing from various sources--the companies
selling HSAs, the clearinghouse websites like e-
healthinsurance, is showing, from a preliminary data
standpoint, that the opposite is happening.
I would like to hear from the experts, what they are
seeing, so, to me, this is a very timely hearing. I would argue
that you can't make conclusions, now that we've just got new
products out there that are just taking place in the
marketplace. This is something that we need to watch very
closely, the data, so that as each product is being sold, it is
incorporated so that we can track this very well.
I think the ability to track this data is much better than
it was a few years ago, so while we see a fight here,
politically or ideologically, on Capitol Hill, over this issue,
I think it's reasonable to conclude that neither side knows
what the answer is.
That's why I think this is a very timely hearing. The end
of the story is, each constituent of ours, whether they work
for a big company, a small company, or are on their own, is
probably facing double-digit health insurance cost increases,
and answers are needed.
We have some answers that are being deployed in the
marketplace. There are more things we're proposing, so I think
this is a very timely hearing, and I look forward to the
witness testimony. Thank you for your indulgence, Mr. Chairman.
Chairman Bennett. Thank you very much. I think we have a
panel of witnesses across the spectrum of experience,
background, and opinion, that can help us get a balanced view
of this.
We welcome Dr. Mark Pauly, who is one of the nation's
leading health economists from the Wharton School at the
University of Pennsylvania, who has written extensively on the
operations of health insurance markets and how public policy
can shape them.
Dr. James Cardon of Brigham Young University, has examined
whether consumers have private information advantages over
insurers, information that could trigger adverse selection and
distort health insurance markets. His most recent research
focuses on the effects of the new consumer-driven health care
choices like Health Savings Accounts.
Jeffrey Closs is President of BENU, a company that provides
benefits choice services to mid-size employers. BENU uses risk
adjustment tools to encourage insurers to compete more
vigorously for a portion of an employer's business and to
provide more meaningful choices for covered employees.
Then Linda Blumberg brings some direct governmental
experience to the table. She is with The Urban Institute, but
has been an advisor to both HHS and OMB, and has studied issues
of risk selection and risk segmentation in voluntary insurance
markets, particularly those involving small employers and
individual consumers.
I welcome all four of you and appreciate your willingness
to come and share your expertise with us. We will hear from you
in the order in which I have introduced you, which means Dr.
Pauly, we start with you.
STATEMENT OF MARK V. PAULY, PH.D., PROFESSOR OF HEALTH CARE
SYSTEMS, BUSINESS AND PUBLIC POLICY,
INSURANCE AND RISK MANAGEMENT, AND ECONOMICS, WHARTON SCHOOL,
UNIVERSITY OF PENNSYLVANIA, PHILADELPHIA, PENNSYLVANIA
Dr. Pauly. I thank you, Mr. Chairman and Members of the
Committee, for the opportunity to testify on adverse selection
in health insurance, and related issues.
The world in which we live is one in which health spending
risk varies before the fact, in the sense that different
consumers reasonably expect to collect different amounts in
benefits from a given policy, because they expect in the
future, to get sick with different frequencies and severities.
Insurers can identify and measure some characteristics that
they know predict above- or below-average benefits,
characteristics such as age, location, and the presence of
chronic conditions. Insurance markets can still function in
such a world, but either premiums or purchases will be
different for different people, and this makes life
complicated.
What will happen depends crucially on whether insurers have
and can use the same information that predicts benefits as
consumers can use. If everyone has the same information, and
the information does predict different risk levels, then
insurance theory tells us that insurers will choose to charge
below-average premiums to the lower risks, and above-average
premiums to the higher risks. Someone who has four times the
expected benefit from a given policy, will be charged about
four times the premium.
At those premiums, insurers will be equally eager to sell
to low and high risks. In insurance theory, this situation of
proportional risk rating will be stable, and probably will be
one in which low risks are no more or less likely to buy
insurance than high risks.
A few very high risks with low incomes may find that
premiums are so high and expenses are so near certain, that
they are just as well off not buying insurance and paying those
expenses directly, when and if they can, but that's the
exception.
Insurance markets, the same theory tells us, will be very
different if insurers do not have equal information that buyers
have, or if insurers are not allowed to use the information
they do have in setting premiums and bidding for business.
In the extreme case in which insurers cannot distinguish
among risks or are not permitted to do so, they will be forced
to charge the same premium to everyone who buys insurance, but
if insurance purchasers know their risk levels, their
willingness to buy insurance at this premium will vary.
Higher risks will be very enthusiastic about buying, since
they can, on average, collect in benefits, more than they pay
in premiums, but low risks may decide not to buy insurance at
all, because it looks like a bad deal to them, or may at least
seek to buy less generous coverage than the high risks desire.
This situation of community rating will be one in which the
low risks are less likely to buy insurance than under risk
rating. In the limiting case in which the low risks bail out
altogether, the so-called ``death spiral,'' the premium
insurers will end up charging to the high risks who remain,
will be the same ones they would have charged under risk
rating, and the effect of community rating will only be to
drive all of the low risks from the insurance market, with
resulting adverse effects on their access to care and financial
stability.
It is in this sense that community rating can be
inefficient, compared to risk rating, since it can make the low
risks worse off and not make the high risks better off. In the
less extreme case in which some low risks might continue to
buy, the high risks could be better off, but the low risks will
still be worse off than they would have been under risk rating.
There will still be inefficiency, compared to the ideal,
because the low risks will choose less coverage than they would
have chosen, if they had faced premiums reflective of the true
cost of their coverage.
Whether there will be cream-skimming, in which insurers are
more eager to sell to low risks than to high, depends on
whether the adverse selection is essential in the sense of
being caused by insurer inability to tell risk apart, or
inessential, caused by regulation or policies which forbid
insurers from using information they have, to set lower
premiums for lower risks.
In the case of essential adverse selection, as in the case
of risk rating, there should be no cream-skimming, because all
potential purchasers look equally profitable to insurers.
Insurers might want to cover only the low risk, but they cannot
tell who is who.
In the less extreme case, the regulation-required community
rating, insurers will try to avoid selling to high risks they
can identify, on whom, as a group, they are sure to lose money,
and there will be cream-skimming.
For these kinds of reasons, some insurance analysts think
risk rating is better than community rating, but many
policymakers and some other analysts do not look at it this
way. They do note the downside of community rating in terms of
squeezing out the low risks, even to the extent of a death
spiral, but policymakers also find much not to like in risk
rating, precisely because the higher premiums for high risks,
may bite into their ability to consume other necessities of
life, if they have low income, and sometimes because observing
higher income, high risk paying more than higher income, low
risks, still looks unfair, especially compared to a
policymaker's dream world in which everybody pays a low
premium.
That this is impossible in a world of competitive, but
unsubsidized insurance, only margins dampens their ardor.
The most obvious way to deal with these problems is to use
regulation and to require insurers to charge similar premiums
or limited premiums for high risk, and forbid low risks from
buying less generous policies, then require insurers to sell
policies to high risks they know will be causing losses, and
when there is enough political nerve, forbid insurers and the
low risks from dropping out, by mandating insurance purchasing.
Measures short of this draconian one, can still lead to bad
adverse selection type outcomes, especially when community
rating forces insurers to ignore information they have. Then
when insurers respond to community rating regulations with
cream-skimming, one needs to write yet more regulations to
require open enrollment and guaranteed issue.
To avoid the death spiral, we move to a regulatory spiral.
As with other kinds of health care regulation, how bad or good
the regulatory outcome will be, seems to vary in practice
across states, depending on characteristics of their potential
insureds and the form and administration of the rules.
In some states, such rules have seriously curtailed the
size of insurance markets, while in others, the main effect is
only discontent among the low risks and the insurers who would
like to sell to them. Still, on balance, community rating seems
to increase the number of uninsured.
The main novel point I want to make here is that recent
research suggests that, both in theory and in practice, there
are ways alternative to regulation to get closer to what
policymakers want, or should want, when risk rating and adverse
selection are possible.
The three kinds of solutions to which I want to draw your
attention are: No. 1, guaranteed renewability at uniform
premiums; No. 2, group insurance; No. 3, high risk pools. I'll
speak most about the first.
The great majority of people who are high risk today, were
not sicker than average at all times in their lives. Data tells
us what common sense and even our bones in the morning tell us,
that even people who are in excellent health, have higher
medical expenses, on average, as they age, and some pick up
chronic conditions.
The age effect on increasing risk is perfectly predictable.
What is not predictable is the random onset of a chronic
condition that makes a person high risk, not only initially,
but for some time to come.
Most medical expenses for people under 65 are not related
to chronic conditions; they come from the bolt-from-the-blue
event of an accident, a stroke, or something that cannot be
predicted well in advance, and this is precisely the kind of
low-probability, high-cost event for which insurance works
well.
But some events are predictable in advance, and then
someone who contracts a chronic condition, gets a double
financial insult. Not only will they have to pay a lot for
their care in the year in which they are diagnosed, but they
will probably--they may have to pay higher premiums in the
future, and if insurance is perfectly risk rated, they are
subject to the risk of becoming a high risk.
A protection against that in the form of guaranteed
renewability exists and was quite common, even in the absence
of regulatory rules. Specifically, renewability at class-
average rates, requires insurers to charge the same premium to
people, regardless of their experience or their risk, when that
has changed after the sale of insurance. It basically means the
insurers ignore new information about the level of risk, and
this has the power to protect people against premium risk.
This feature is not free, of course. Policies that contain
it, must have high initial premiums, front-loading, than would
premiums for which the insurer retained the right to increase
premiums for people who contracted a chronic illness, but it is
easy to see why rational, foresighted people, would prefer the
slightly more expensive mature policy.
Federal law now requires guaranteed renewability, but our
research on data in a period when it was not required by
Federal law and not required in many State laws, produces the
result that there is very strong empirical evidence consistent
with guaranteed renewability, in that the premiums charged in
the individual insurance market, which is most subject to risk
rating, are much higher for lower risks than for higher risks
than would be consistent with proportional rates.
Chairman Bennett. Dr. Pauly, can I ask you to summarize?
Dr. Pauly. Yes.
Chairman Bennett. This is fascinating stuff, and your whole
statement will appear in the record.
Dr. Pauly. Thank you.
Group insurance can avoid adverse selection, fundamentally
in two ways: The employer will limit the range of choices,
which can limit the possibilities for adverse selection, but
more fundamentally, in most group insurance, the employee who
chooses the lower cost premium policy, or who chooses to have
no insurance, will not recapture in cash, all of the money that
has been saved by making that choice. In that way, people are
induced not to engage in adverse selection, even if they are
low risk.
My conclusion about the current functioning of insurance
markets, is that adverse selection is not, in general, a severe
problem, nor is its mirror image, risk rating, which causes
high risks not to have coverage. To the extent that there are
problems for high risks, my suggestion is that an appropriately
run plan of guaranteed renewability of high risk pool, can
solve that problem.
My fundamental amateur judgment on policy is that, of all
of the things that are wrong with America's health care and
health insurance markets--and there are many--these various
risk segmentation issues so prominent in insurance theory and
much policy discussion are a distraction. Not that there is no
problem there, but compared to other issues like getting
subsidies to people of all risk levels to help them afford
insurance, if they are low-income, or making health care, if we
can, cheaper and just as good, this seems to me to be a very
low priority item.
[The prepared statement of Mark V. Pauly appears in the
Submissions for the Record on page 30.]
Chairman Bennett. Thank you very much.
Dr. Cardon.
STATEMENT OF JAMES H. CARDON, PH.D.; ASSOCIATE PROFESSOR OF
ECONOMICS, BRIGHAM YOUNG UNIVERSITY, PROVO, UTAH
Dr. Cardon. Mr. Chairman and Mr. Ryan, it is good to be
here today.
Insurance is desirable because it exchanges a fixed premium
for a reduction in risk. Adverse selection is caused not by
imperfect information about future expenditures, but by
asymmetric information. Buyers and sellers of insurance may
have private information about those risks.
There is potential for adverse selection, anytime either
buyers or sellers have significant informational advantages.
Akerlof first illustrated the problems of private information
advantages in the used car market, the market for lemons.
Seller's private information about car quality leads to an
unraveling of the market in what is sometimes called a death
spiral. Rothschild and Stiglitz extended the argument to the
case of insurance, and identified a simple market solution of
this information problem that effectively identifies and
separates, high and low risks.
In this separating outcome, risk types are fully revealed,
and the only deviation from the world of symmetric information
is that the low risk types are forced to accept lower levels of
coverage.
It is a mistake to conclude that the separating outcome
defeats the purpose of insurance, since health care expenditure
are unpredictable, even given detailed information about
demographics and medical conditions.
As used and useful as this model is, there is something of
a divergence between the theory and its application to real
markets, and this has led to widespread misinterpretation of
the statistical evidence.
There is a crucial difference between selection based on
private information and selection based on public information,
such as demographics and income. Theoretical models that lead
to adverse selection are concerned with private informational
advantages, and public information poses no problem for
markets.
In a paper published in 2001, Igal Hendel and I built a
statistical model to test for the presence and importance of
asymmetric information in health care markets. The question is
whether there is evidence of private information that can
produce adverse selection.
The test that we used is based on the link between
insurance choices and subsequent consumption of health care.
Intuitively, this test is based on whether this link can be
explained by mutually observable variables, or whether private
information plays a significant role.
We found that the link between health insurance choices and
health care consumption, is mostly explained by income and
other demographics. As is normally the case, expenditures do
vary predictably with income and these demographics, but most
of the variation in expenditures is purely random and
unpredictable.
Our research shows no evidence of private information
leading to adverse selection in the health insurance market.
The life insurance market is similar in many respects to the
health insurance market. Cawley and Philipson find that the
data are inconsistent with private information on the consumer
side. Instead, the authors suggest that the insurers in this
market may have the informational advantage.
Similar results have been found in the auto insurance
markets. The papers cited here should cast some doubt about the
presence of adverse selection. A failure to find evidence of
informational advantages leading to adverse selection in a
given market, does not, of course, mean that it cannot or that
it does not occur; rather, it means that the problems that do
exist are swamped by other factors, or that the problem has
been managed by consumers or insurers in some other way.
Many cases of so-called adverse selection are due to
deliberate neglect of available information.
One commonly made argument against Health Savings Accounts
has been that they will lead to either increased risk
segmentation and a separating outcome, or to the premium death
spiral in which exit of the healthy from comprehensive plans
raises premiums to the point that the market for such insurance
collapses.
At a common sense level, I believe that concerns that HSAs
will distort markets, are greatly exaggerated. There is
evidence that informational advantages are often either small
or two-sided, with both buyers and sellers having private
information.
As far as risk segmentation is concerned, HSAs are similar
to existing high-deductible or other plans with high levels of
cost-sharing, and benefits managers know how to manage
enrollment among a variety of plans by adjusting premiums and
plan benefits.
After all the analysis, it's markets that will provide the
final test. If HSAs work, then they will become popular. If
they do not work, then they will disappear.
Traditional plans will continue to be available, and
decisions are usually biased against new products. If firms
find that HSAs are not a good match for their employees, they
will drop them.
HSAs will likely become a useful alternative to less
comprehensive insurance or managed care, and they are worth a
try. Thank you.
[The prepared statement of James H. Cardon appears in the
Submissions for the Record on page 39.]
Chairman Bennett. Thank you very much.
Mr. Closs.
STATEMENT OF JEFFREY M. CLOSS, PRESIDENT AND CEO, BENU, INC.,
SAN MATEO, CALIFORNIA
Mr. Closs. Good morning, Mr. Chairman and Members of the
Committee. I'm pleased to be here today.
Our Company, BENU, offers a meaningful choice of health
insurers to employees of small and mid-sized companies. We're
able to offer this expanded choice by reallocating premium to
health insurers to compensate for adverse selection.
We currently operate in the states of Oregon and
Washington, with Kaiser Permanente Group Health Cooperative and
Cigna Health Care, and beginning January 1st, BENU will be
available in the Washington, DC region, with Kaiser Permanente
and Cigna Health Care.
Consumer choice of health insurers doesn't exist for small
and mid-sized companies. Why? Adverse risk selection.
Let me give you an example: A marketing executive for Group
Health told us of their very successful program to treat
diabetics. He described their sophisticated prescription
system, which flags new insulin prescriptions, which then
prompts a nurse to call the diabetic and offer education on
monitoring and controlling blood sugar, as well as to schedule
appointments with the dietician to review nutritional needs,
and more testing for additional diseases.
I was impressed with the comprehensiveness and
effectiveness of this care. But when I asked, why not encourage
all diabetics to join Group Health, he responded, ``We'd love
to, but we can't. We'd go out of business.''
The problem is, the premium payment will not cover the cost
of treating a diabetic, no matter how efficient the care is.
So, why are premiums insufficient?
Because employers pay health insurers, based on an average
cost payment. Health insurers charge the same rate for all
potential enrollees within a company.
The problem is that individual members have vastly
different expected costs, depending on factors such as age,
gender, and most importantly, the level of chronic illness they
have.
We know that a person with diabetes will, on average, cost
many times that of a 20-year old, yet the health plan that
enrolls either of these, receives the same payment. On a pure
financial basis, whom would the insurer rather enroll?
Obviously, the healthy.
It's a shame that Group Health has a disincentive to
promote their award-winning diabetic care program. how do we
correct for this?
BENU solves this by increasing the payment to the insurer
for the more costly diabetic member, while lowering the payment
for the less costly healthy member, what we call risk-adjusted
payments.
Employers continue to pay BENU, average cost payments, but
what's transformational is that BENU pays insurers risk-
adjusted payments. Insurers now get a fair payment for both the
sick, as well as the healthy.
The large chart over in the corner demonstrates the amount
of premium that we actually move between carriers by employer
group, which we'll probably touch on later. [Chart appears in
the Submissions for the Record on page 49.] The results are
profound:
Health insurers now have an incentive in enrolling the
chronically ill, as well as the healthy. They won't fear
financial losses, if they enroll a disproportionate share of
the diabetics.
Employers can now offer a choice of truly competing
insurers, and provide a fixed subsidy for the lowest cost, most
efficient plan.
Employees can choose to buy up to more expensive plans and
pay the difference. This creates savings for the employer and
controls health care inflation.
In fact, BENU has saved its customers an average of 15
percent on the total employer premium cost. In addition,
consumers are significantly more satisfied.
Our customers tell us that their employees love the broad
choice. Consumers can now choose from a comprehensive closed
network HMO from Kaiser Group Health, an open access PPO from
Cigna Health Care, or a consumer-directed plan with a Health
Savings Account.
Consumers are making decisions based on their own
individual financial and health needs, but, more importantly,
efficiency is brought to a health care system badly in need of
it. Insurers compete for the right reasons, providing high
quality care to keep their members. If they don't, employees
can easily move to another insurer that will satisfy their
needs.
While free-market forces drive needed efficiency, the
social aspect, where the chronically ill receive care at prices
they can afford, is maintained.
The truth is, we expect our health insurance carriers to be
more than just insurance. We expect them to be a good service
plan, taking good care of the healthy and chronically ill, and
we expect them to be part social program, spreading the cost of
the health care evenly among all participants.
Not surprisingly, with the way insurers are being paid,
they're having a hard time being either. Mr. Chairman and
Members of the Committee, what's wrong with the current system
is not how we fund health care, but how we pay insurers.
We fund health care by charging everyone the same premium
for the same plan, no matter how sick they are, but instead of
paying the insurer the average cost premium, we should adjust
payments to insurers, based on the chronic illness of those
enrolled.
BENU enables small and mid-sized employers to offer a
competitive choice of insurers, delivery systems, health plans,
and prices to their employees, and reallocates premium to
insurers to compensate for the adverse selection that
inevitably occurs. The result is a competitive consumer market
that lowers costs, satisfies employees, and motivates insurers
to provide value to the chronically ill. Thank you for your
time today.
[The prepared statement of Jeffrey M. Closs appears in the
Submissions for the Record on page 42.]
Chairman Bennett. Thank you very much.
Dr. Blumberg.
STATEMENT OF LINDA J. BLUMBERG, PH.D.; SENIOR RESEARCH
ASSOCIATE, THE URBAN INSTITUTE, WASHINGTON, DC
Dr. Blumberg. Thank you, Mr. Chairman and distinguished
Members of the Committee, for inviting me to share my views on
adverse selection and health----
Chairman Bennett. Could you pull the microphone a little
closer to you?
Dr. Blumberg [continuing]. For inviting me to share my
views on adverse selection in health insurance, and its
implications, when expanding consumer choice in private health
insurance markets. I applaud the Committee for taking the time
to carefully consider these issues, which are of paramount
importance to individuals' access to health care coverage and
medical services.
In order to understand health insurance markets, there is
one overarching fact that must be understood: The distribution
of health expenditures is highly skewed, meaning that a small
fraction of individuals account for a large share of total
health expenditures.
Because of this fact, the gains to insurers of excluding
high-cost people, swamp any possible savings from efficiently
managing care for enrollees. The incentives for insurers to
avoid high-cost, high-risk enrollees are, therefore,
tremendous.
Greater risk segmentation of the market means setting
individuals' health insurance premiums to more closely reflect
each individual's expected health care costs. Conversely,
greater risk pooling implies increasing the extent to which
individuals with different expected health care spending
levels, are brought together when determining premiums.
Providing new insurance options is one way, intentionally
or not, that the extent of risk segmentation can be increased.
Reforms that increase risk segmentation, are appealing to some
because they promise, and sometimes deliver, lower premiums for
currently healthy persons, and because the majority of people
are healthy.
However, gains from segmenting healthy groups can occur
only if premium costs for the unhealthy are increased, or if
the unhealthy are excluded from the market to a greater extent
than is true today.
Examples of proposed and already implemented reforms that
will increase risk segmentation in private markets, are Health
Savings Accounts, tax deductions for the premiums of high-
deductible policies associated with HSAs in the private non-
group market, association health plans, and tax credits for the
purchase of non-group insurance policies.
While risk segmentation increases the cost of coverage for
the unhealthy, the isolated instances where states have forced
greater risk pooling, have not been successful, either. Efforts
at pooling have been limited to a small population base, and
have been foiled by individuals and groups that opt out of our
voluntary private insurance markets.
Addressing the problem will require subsidization of the
costs associated with high-cost individuals, with the financing
source being independent of enrollment in health insurance--
ideally, all taxpayers.
In this way, the unhealthy could be protected from bearing
the tremendous costs of their own care, while there would be
little to no disincentive for the healthy to give up coverage.
Three examples of policies that would move closer to such a
paradigm are: (1) Dramatically increasing funding for state
high-risk pools, and making the coverage both more
comprehensive and easier to access; (2) Having the Federal
Government take on a roll as public reinsurer, particularly for
the private, non-group market and for modest-sized employers;
and (3) A more comprehensive strategy would allow groups to
continue to purchase insurance in existing markets under
existing insurance rules, while each state provides new
structured insurance purchasing pools. Through these new pools,
employers and individuals could enroll in private health
insurance plans at premiums that reflect the average cost of
all insured persons in that state.
For the following reasons, introducing greater choice
within existing insurance pools, will not solve the problems I
described. In fact, doing so will likely exacerbate them, even
given the best available risk adjustment mechanisms.
First, it is not sufficient to spread risks only within a
particular insurance pool. Second, benefit package design is an
effective tool for segmenting insurance pools by health care
risk. Offering less than comprehensive insurance will tend to
attract healthier enrollees.
Third, in private markets where differences in actuarial
value of plans can be quite large, and where people have the
opportunity to opt in or out of the market, risk adjustment
becomes substantially more difficult. Risk adjustment has been
used in the Medicare Program, and is universally considered to
be inadequate in that experience. Finally, it is not even clear
that employers will have a strong incentive to want to risk-
adjust across plans.
Although most employers want to look out for the well being
of all their workers, they face incentives to keep health care
premiums down, while keeping their highest paid workers
satisfied. HSAs may provide employers with an effective tool
for responding to these incentives, but place a greater share
of the health care financing burden, directly on the sick,
while higher paid employees can be compensated via the tax
subsidy.
Further segmentation of risk will not improve the social
welfare in the United States. Addressing the health care needs
of all Americans and protecting access to needed services for
our most vulnerable populations, those with serious health
problems and those with modest incomes, will require broad-
based subsidization of both those with high medical costs and
income-related protection for those unable to afford even an
average-priced insurance policy. Thank you very much.
[The prepared statement of Linda J. Blumberg appears in the
Submissions for the Record on page 49.]
Chairman Bennett. Thank you. We've been joined by Senator
Reed. Senator, do you have an opening statement? We'd be happy
to hear from you before we start the questioning.
OPENING STATEMENT OF SENATOR JACK REED, U.S SENATOR FROM RHODE
ISLAND
Senator Reed. Thank you very much, Mr. Chairman. Just
briefly, this is a very important topic, given the fact that we
have legislatively committed to Health Savings Accounts for
over 10 years, with a price tag of about $70 billion, so I
think we have to ask the question, are we getting our money's
worth in terms of broader coverage and more efficient coverage.
The issue of adverse selection is a critical component to
answering that question of whether or not these Health Savings
Accounts are literally allowing healthy individuals to
accumulate, through the tax system, wealth, while not serving
the needs of lower-income Americans and particularly very ill
Americans.
Now, I think that's at the heart of this issue, and I
commend the Chairman for raising the issue and for bringing
together a panel of experts to do this.
Mr. Chairman, I think that sort of summarizes where we are,
and I'd be happy to claim my time in questioning at the
conclusion of your questioning.
[The prepared statement of Senator Reed appears in the
Submissions for the Record on page 30].
Chairman Bennett. Thank you very much.
Well, you've heard each other on the panel, and what I like
to do in these hearings, because they are not legislative
hearings, is move more to an attitude of a panel discussion
than a direct question-and-answer session. Now, we stay in the
framework, in that each Member is allowed to conduct the
discussion, if you will, but having heard the range of opinions
here, I'd like to get a little interaction going.
Dr. Blumberg is fairly firm in her conclusion about Health
Savings Accounts and how dangerous they are. I don't want to
put words in your mouth. You didn't use the word,
``dangerous,'' but I get that sense from your testimony.
Dr. Cardon, you've done a lot of research on this. Can we
have an exchange between the two of you, and then the others
get into it, as to where you are on this one?
Dr. Cardon. OK.
Chairman Bennett. Bring the microphone closer to you, as
well.
Dr. Cardon. Well, I don't think we know how these things
are--I think Mr. Ryan said what I believe. We're not sure how
these things are going to play out.
I don't think they are that dangerous, because I am
skeptical about the true adverse selection. I guess we've had
the range of definitions of adverse selection here.
The way I have defined it, I don't think there's a lot of
it. It's driven by private information, and not by things that
can be observable, including things that would be used in a
risk rating system.
I think that there's some--I just don't think the dangers
that are suggested with these things, are as real as might be
suggested.
Chairman Bennett. Dr. Pauly, I was interested in your
concluding remark that this whole debate is something of a
diversion from the real structural problems that face our
health care system.
I have the same feeling. I think some of the truly
structural problems that we face, are being ignored in much of
the debate, and at this series of hearings, we're trying to get
at some of those problems.
Do you have a comment here on how important is the issue of
adverse selection, and how valuable is the question of--is the
opportunity of consumer choice? Is consumer choice a
distraction?
Dr. Pauly. All right, actually I think that Dr. Blumberg
and I both agree with you, that the more fundamental questions
are ones that involve helping people afford insurance and
making insurance for the average person work well.
In terms of--let me make two comments: One is whether
Health Savings Accounts create adverse selection that we should
be terribly worried about, and then what should we be worried
about?
First of all, if low coverage policies do attract low
risks, so do aggressive HMO plans. In a way, they are certainly
no worse, and we've been able to deal with HMOs and tolerate
them.
More importantly, if the HSA plan is offered in an
individual setting, as I've already pointed out, when the
individual insurance is already risk-rated, the HSA insurance
would also be risk-rated, and if the insurer knows what it
seems to know, which is as much as the person knows, there
would be no adverse selection that would go on there. There
might still be a choice by healthier people to take the HSA,
but they would pay--their doing that would not cause the high-
risk to pay anything more, because there is no cross-
subsidization.
In the group setting, of course, it depends on what
employers do. I agree with Dr. Blumberg, at least, I think,
implicitly, that it would be possible for a foolish employer to
set up an HSA option and then set the reward for choosing the
HSA in such a way to create adverse selection.
I think that with the kind of devices that Mr. Closs talked
about, or some other less formal devices, that insurers,
employers, and benefits consultants know about, it's possible
to control the extent of adverse selection, essentially by not
offering too large a reward to the low risks for the plan that
they choose, so that not to make it excessively attractive.
Then I guess the final way to look at this is, in a worst-
case scenario where all the other plans disappeared and only
the HSA plan was left, if that's a decent plan, which I think
it is for most Americans--it may not be the best of all
possible worlds, but it's not the end of the world, either--
but, more generally, of course, the main adverse consequence of
adverse selection is that it would wipe out choice.
I guess, to address that specific question, I think there
is enormous evidence that Americans differ substantially, not
only in terms of how they want their health care and what kind
of health care they want, but how they want it controlled.
Some people want to control it themselves by paying out of
pocket; other people are happy to have a managed care plan say
no for them; still other people are happy to spend more money,
because that's what it takes to be able to have full insurance
coverage and whatever you want.
Of course, all of us would like cheap insurance that puts
no restrictions on us, but, this side of the grave, that's not
something we're going to see.
I think that offering those options to people who seem to
have very different preferences in terms of how they want to
see their health care financed and ultimately controlled, is
part of the genius, in a way, of the American system of
allowing a pluralistic arrangement where there are different
strokes for different folks, makes the most sense.
Chairman Bennett. Your description of what we want is the
subject of Robert Samuelson's op ed piece in this morning's
Washington Post, when he says Americans want full control of
choice of their doctors, full access to all services at all
times, and very low premiums.
Dr. Pauly. Even grownups are still teenagers when it comes
to health insurance.
[Laughter.]
Chairman Bennett. It's come to that. Mr. Closs, react to
Dr. Blumberg about your experience, and then, Dr. Blumberg,
react to Mr. Closs's experience in the marketplace. We've got
the two professors, and now you're the practitioner here.
Mr. Closs. You know, Dr. Pauly actually set it up great for
us, in that everybody has a different need, and if we try to
dictate what each individual employee needs, and if it's an
HMO, well, we were there once before, right, when we had
everybody into an HMO, and that didn't work out so well.
I think we're potentially setting up the same thing, which
is that if everybody moves into a consumer-directed plan, high-
deductible HSA, by force, you're going to end up with the same
situation.
The fact of the matter is, everybody has different needs.
Not everybody wants to be engaged in the retail purchase of
health care. They don't want to go negotiate with their doctor
about how much that visit is going to cost. Some people prefer
that closed system HMO where everything is taken care of.
I think, really, our mission is to provide all of those
choices in a competitive marketplace, and let free-market
forces decide which of those plans provides the most value and
the best efficiency at the right price for each individual.
I think that's kind of one of our fundamental business
premises, that choice is good; employees want choice; they want
to determine how much they're going to spend; and they want to
determine how much coverage they get for that.
In terms of adverse selection, I guess I have a couple of
comments: One is, there's a lot of talk about what do we do to
prevent it? One of the things that happens is, I think, if we
get so focused on preventing adverse selection, what ultimately
happens is, we lose choice.
We lose a differentiation among products and insurers in
the marketplace. Why? Because the way you minimize or mitigate
adverse selection is to make everything the same, right? That's
counter to what we're trying to do. We want to have
differentiated choice for the individual.
If risk selection happens, adverse selection happens, kind
of our philosophy is, then compensate for it. Don't spend so
much time trying to prevent it, because of all the bad things
that come with the prevention of adverse selection, but when it
happens, the key is that the carriers need to get compensated
appropriately for the risks that they get.
If they do, they now have an incentive to take care of that
member. I think that's been the imbalance in this system, the
connection of those two.
Chairman Bennett. Do you buy that, Dr. Blumberg?
Dr. Blumberg. What I agree with is that you expend a lot of
resources to try to avoid adverse selection, and that's an
efficiency loss; that's a lot of wasted time and effort.
I agree that insurers will always be better than any
analyst I can think of who attempts to stop insurers from
pursuing enrollment of a lower-cost risk group, using risk
adjustment, regulations, or other techniques.
They are always going to be better than us at it. It's
their job; they do it all the time. That's why I'm concerned
about the direction of the policies that have either been
implemented recently or are being seriously considered. Because
although we have very limited experience with HSAs, as everyone
has acknowledged, and we don't know exactly how bad the risk
segmentation is going to be, all of these kinds of policies,
the HSAs, the tax credits, the further deductions for high-
deductible policies, the association health plans, will all
have a tendency to move our market to a more segmented risk
scenario.
With that, the proposals are not joined by other proposals
that would compensate for this greater extent of segmentation
that we're probably making. These proposals, therefore, do not
acknowledge that there's no way we're going to be able to stop
it from occurring, regardless of our different predictions of
what the magnitude is going to be.
What I'm suggesting is that we look at proposals that are
specifically designed to assist those individuals who are most
vulnerable in these markets, and those are the people who incur
high-cost illnesses and individuals who are of low and modest
incomes.
To that extent, I agree with what Mr. Closs is saying.
Chairman Bennett. Mr. Ryan.
Representative Ryan. This is very interesting. I want to
ask for a reaction on something that's happening right now,
which is--I mentioned this in my opening statement, the FEHBP,
the Federal Employee Health Benefit Plan. I'd like to ask each
of your predictions on what you think is going to happen.
Now, this is the largest health insurance pool in the
country with nine million Federal workers and their families.
What OPM just did, the Office of Personnel Management, who is
in charge of putting this together, this year--I think the open
season starts in December--Federal employees will be able to
choose HSAs.
To avoid these risks and adverse selection issues, they
basically made the premium virtually identical to the other
common low-
deductible premiums, with all the other plans.
There has been an adjustment made by OPM, consciously, to
try and avoid this, based on a big premium differential, so
that's moving forward. We'll see this happening now, and from
what we've been seeing from other testimony, is that the
Federal Employee Health Benefit Plan is sort of a trend-setter
in the large company marketplace.
We're already seeing a lot of early data coming in, that
small and medium employers and the individual market, are
really going toward HSAs. The adverse selection data that's
coming in is splotchy. It's showing that sort of the opposite
is occurring, but, again, it's too early to see.
What's your impression and your belief and your prediction
on what this new policy will have? There are nine million
people in this large pool, now having access to these plans.
Will adverse selection occur, and, because of the premium
adjustment, do you think that the bottom is going to fall out
and the healthy and the wealthy employees in the Federal
Government are going to flock to these and you'll have death
spirals in the rest of the FEHBP? I'd just be curious to have
everybody's reaction on that, and if you have studied this.
Dr. Blumberg. Well, it's an interesting issue, given that
the structure, as you said, is that they're having the same
premium being charged. I'm assuming that whatever extra
contribution that the individual is making or the Federal
Government is making into that plan, is going to go into the
account, as opposed to the premium, so it still will be more
attractive to individuals who have low expected health care
costs. This is because they could use those dollars, not just
for potential savings for retirement, which a lot of young
people aren't that interested in doing, anyway, but also they
can use it for discretionary types of medical care that aren't
covered by traditional insurance or even by the high-deductible
plans; things like eye glasses, cosmetic surgery and
nonprescription drugs, those kinds of things. I think it still
will be more attractive to the low cost for those reasons, and
the premium savings.
Will they be able to prevent the death spiral? You know,
FEHBP has some very clear experience with death spirals in the
context of their Blue Cross-Blue Shield plan. Originally, they
had two options, High Option and Standard Option Blue Cross-
Blue Shield, with deductibles that were not that different, but
there was some savings from taking the higher deductible plan.
The selection that occurred across those two plans, drove
the premiums apart to the point where over time--and it did
take time--the High Option Plan was no longer sustainable and
was dropped a couple of years ago from FEHBP.
Do I have great confidence that they are going to be able
to avoid segmentation? No, I don't have great confidence. Does
it take quite a long time for death spirals to occur? It does
take years. I don't think you're going to see the impact of it
over a year or 2 years, but you'll start to see segmentation of
the pools, if we can collect appropriate data. I don't know
what OPM is doing to track what's going to be going on. It
would be great if they were collecting data on the health
status and the sociodemographics and the wage levels and the
family status of the people that are enrolling in these
different plans, so that we can really do a good assessment.
But because I don't have great confidence in our ability to
risk-adjust or to have a strong incentive to risk-adjust in the
long run, I still have concerns.
Dr. Pauly. Well, my empirical answer to almost any question
these days is no more than 15 percent, so I guess I would use
that here. I think the number of Federal employees that are
likely to enroll in this plan, would be no more than 15
percent.
I do think, though, it may well be, as I said in my
remarks, that a high-deductible plan is the efficient plan, is
the desirable plan for healthier people to use, compared to
people with chronic conditions. In the best of all possible
worlds, we'd like to have people have the efficient plan.
The way to--the question, though, is, will there be adverse
consequences for the people who are at higher levels of risk?
My answer to that is, in a sense, that's up to the Federal
Government in terms of what premiums it wants to charge for the
high-option plans, relative to the low-option plans.
There's no law of nature that requires it to allow the
premiums for those plans to rise, relative to the HSA or to
what already exists in fairly aggressive managed care plans.
That can be adjusted, and if you say, as you might be thinking,
``Well, what about total health care costs,'' then, if we don't
penalize the high risks when the low risks are, in a sense,
getting more than they should? The answer is, at least in
economic theory, that you can adjust the money wages so that
your total compensation budget stays the same.
The general philosophy--Mr. Ryan, you said the Federal
employee plan is a trend-setter for plans around the country.
There is one enormous difference: It offers many, many more
plans than almost any private firm does. To some extent,
perhaps Dr. Blumberg is right, it has more of a problem with
the potential for selection, given the wide variety of plans.
But even so, with appropriate anticipation of what kind of
risks will enroll in which plan, it's definitely possible to
set the premium differentials so that people end up where they
should be. As I said, the kind of last resort to kind of make
everything work out right, is to adjust the money wages, so
that the total compensation cost stays within whatever target
you set.
Mr. Closs. A couple of comments: One, I suspect that the
risk selection will be a little higher in an HSA type plan. My
personal opinion is that if people are sick and they know they
are going to consume services, most of those services are going
to happen on the other side of the deductible, all right?
So, they are going to use their cash, they're going to go
past the deductible, and when they see that, they're most
likely to pick a more comprehensive plan and not be exposed to
that big out-of-pocket difference.
One would think that if people do have that information as
they're purchasing, they may, in fact, end up with a more
comprehensive plan and the more healthy will end up in a
consumer-directed plan.
Again, our view is that that's fine, because we're going to
compensate the carriers appropriately for that different risk,
such that they are paid right.
What I want to do is talk just a little bit about the
transition, and, as you said, how that moves into the large
employer market, because our world is employer-sponsored.
Large employers, when they start to introduce a consumer-
directed plan, they have less issues than the employer segment
that we deal with, in large part because they are all self-
funded. You know, the employer is the insurer, they have their
own risk pool, so the risk pool is intact, no matter what
people choose.
What changes is when you go into a smaller employer
environment or mid-sized employer, and they buy insurance. If
you have two insurance companies in that environment, that's
where the dynamic occurs where the insurers won't share that
business.
I think that's what we're trying to fix, is the fact that
now those employers are really forced to make one choice, and
that choice isn't going to fit everybody. If they go to that
consumer-directed plan, it may be good for some, but it's not
going to be good for all.
Really what we see is employers forced into a position
today in this small and mid-sized segment, where they have to
buy a single insurer, and generally they get one product. I
mean, in our markets that we're in now, 80 percent of people
have no choice. Only 20 percent have a choice of carriers.
I think it's important to understand the dynamic that
occurs in an insurance environment, to figure out how we can
make sure that we create a competitive environment where they
can get all those plans and the death spiral won't happen.
Chairman Bennett. Did you say 80 percent have no choice, or
80 percent have a choice?
Mr. Closs. Eighty percent of employees in the States of
Oregon and Washington, have one carrier and one plan.
Chairman Bennett. So they have no choice?
Mr. Closs. They have no choice.
Chairman Bennett. I see.
Representative Ryan. My time is up.
Chairman Bennett. Senator Reed.
Senator Reed. Well, thank you very much, Mr. Chairman, and
thank you to the panel for their insights.
I was struck by Dr. Cardon's conclusion that at this point,
it's hard to tell what the effect of HSAs are in terms of their
impact on the health care system. That raises to me, the
question of, since we're spending $70 billion already in the
next 10 years, and the President is calling for $40 billion
more, are we getting what we're paying for, particularly with
respect to what I believe are the policy objectives, or should
be the policy objectives, which are to broaden coverage and to
reduce the premiums to make it more affordable, which are
obviously related issues.
Dr. Pauly, do you think Health Savings Accounts are
contributing in a meaningful way to increasing coverage and
reducing the cost of premiums to the average person?
Dr. Pauly. Well, of course, I need to say, not yet. Nobody
knows, but the potential--the primary potential advantages of
Health Savings Accounts is, as I mentioned in my remarks, that
by having people pay more out of pocket, they will be more
prudent in their choice of health care.
That, of course, you could say, for someone who chooses an
HSA, that's kind of the bargain they make. They agree to have
less financial protection and more of a chance of getting a big
bill that wiped out the account, but in return, on average,
they'll end up being more frugal and spending less.
I think, you could just say, ``Well, just let individuals
choose HSAs, those who like them,'' but I think that from a
general public policy point of view, I think there's pretty
strong evidence that when the middle class chooses expensive
health care, the premiums rise for everybody, and it's those
rising premiums engendered by excessive insurance coverage and
excessive health care purchases by people like me, that are
causing health insurance to be un-
affordable to lower income people.
If you ask me what's likely to be the greatest benefit of
HSAs or any other cost containment feature, managed care or
HMOs, I would include as, you know, the Gold Dust Twins of cost
containment, and it is--the people who buy those plans can make
their own decisions, but the reason why the rest of us have an
interest in what those people do, who are generally not poor or
near poor, is because there is this spillover or trickle down
effect.
Then there has been some intriguing data from the HSA
experience, which suggests that a surprisingly large fraction
of people who bought those plans, were people who had formerly
been uninsured. I don't have an easy explanation for that, but
these days, I'm happy to hear good news, so I count that as
good news.
Senator Reed. But let me return----
Dr. Pauly. But I think the main point is that their primary
advantage, I think, is cost containment.
Senator Reed. Cost containment, so the other objectives,
which would be essentially expansion of coverage, is probably
less--not well served by HSAs?
Dr. Pauly. No. I think that's right, and that's well served
by tax credits to help low-income people afford insurance.
Senator Reed. That gets to the point of tax advantages or
the true nature of the tax system to relatively high-income
people who have tax liabilities.
Dr. Pauly. Yes.
Senator Reed. Do you know, offhand, how many Americans
don't pay taxes because they work, but they don't get to the
point where they're paying income taxes?
I mean, my impression is, as I go through Rhode Island,
that there are lots of people working 40 and 50 hours a week at
very low-income jobs, who don't have health care, and would not
be enticed to an HSA, because simply their tax liability is
minimal. In fact, they pay more in payroll taxes than they do
in any type of income tax.
Dr. Pauly. Well, I think that's right.
Chairman Bennett. Twenty percent of working Americans do
not pay income tax.
Senator Reed. That would translate into a lot of people who
would not essentially be enticed into the HSA model, because it
doesn't make any real economic sense to them.
Dr. Pauly. I think that's right. Any plan whose advantage
is tax deductibility, obviously only matters to people who have
an income level at which that's relevant, or a tax exclusion.
In a way, what HSAs do is kind of level the playing field
for those who do pay taxes, so that they will not be biased
toward choosing excessively generous coverage and might decide
to choose a plan that makes them somewhat more frugal, which
may provide benefits to others. I guess the implication is, if
you want to help the bottom 50 percent, you have to go to
refundable tax credits.
Senator Reed. But the other aspect here is--and I guess I'm
not talking with any quantitative data backing me up, other
than my own sense of things--is that if you feel healthy, your
sense of how much health care you need and how well you're
going to tolerate the future, increases.
To a relatively healthy person, these HSAs are appealing, I
would think. They've made a conscious decision that they don't
need all the bells and whistles on a big plan, and so they say,
``I'm a healthy person, I've got good genes,'' and it seems to
me that this adverse selection issue is based not on any
economic model, but just on sort of common sense or a common
tendency of, if I'm healthy, I can get a tax break; I don't
think I really need insurance. That might even account for
those people who didn't have insurance before, and now since
they have a tax break, they buy insurance.
It goes to this issue, I think, of what kind of people
you're going to find in these HSA arrangements.
Dr. Pauly. Well, it is an effort to even things up. Now, if
you're not healthy and you buy a very comprehensive plan, you
get a big tax break, and so we're trying to be fair to the
healthy and wealthy, as well as to the unhealthy and not
wealthy, but I think, in terms of a factual matter, the
question of who will choose HSAs and what their risk level will
be, is more complicated than you think.
Of course, it depends on what the alternative plan would be
that they might choose. If the alternative plan is actually the
kind of plan I have, which has a smaller deductible, a $500
deductible, but then copayment and out-of-pocket limit which is
higher than the typical HSA deductible, if I were a high-risk
person, I'd actually be better off in HSA/MSA plan than I would
be in my current plan. They're actually compared--of course,
compared to insurance that pays 100 cents on the dollar for
everything, which nobody has anymore, HSAs do look more
attractive to low risks, but compared to the alternative kinds
of insurance that most people have, including what's in the
Federal employees' plan, for the really high-risk people, the
sort of stop-loss feature of most HSA plans, actually may mean
they're better off than with the other.
Senator Reed. Thank you, Dr. Pauly. Thank you for your
response. Dr. Cardon, and then I'll ask Dr. Blumberg. I'll do
the academicians first.
Dr. Cardon. Same question?
Senator Reed. Any comment you have based on this.
Dr. Cardon. One comment I would have is, so, you're feeling
good today and you think you have good genes. Well, just how
sure are you? I think that there's a behavioral thing here that
probably explains Dr. Pauly's 15-percent number.
People are uncomfortable with deductible plans, I mean, to
some degree. I think that there is always going to be a
tendency to sort of err on the side of caution and go toward
the comprehensive plan, and I think that limits a lot of the
selection that otherwise might occur.
There are other things, too. I mean, if I feel healthy, but
I have two kids, how healthy are they? I'm not basing my
selections, just on my own health, but on the sort of average
health in a family, and that sort of muddies it up quite a bit.
Senator Reed. Thank you. Dr. Blumberg, your comments?
Dr. Blumberg. Thanks. First, with regard to objectives of
our spending, I'd just like to say that in times when we have
scarce resources, and we seem to always have scarce resources,
I'd much rather see that our subsidies were being directed to
those who are least likely to have health insurance in the
absence of those subsidies.
I would suggest, and I think it would be hard to dispute,
that the healthy and wealthy are not the ones that are least
likely to have health insurance, in the absence of subsidies.
While we do have some other subsidies that are upside down in
our system, I would say that it doesn't make a lot of sense in
terms of trying to expand health insurance coverage, to direct
more subsidies to that well-off segment of the market.
In addition, I have relatively great skepticism about the
potential for savings or the cost containment effect of HSAs.
The reason I'm skeptical is because the bulk of dollars that
are spent will still be in excess of that deductible.
Roughly 80 percent of the dollars in the health care
system, will occur over those deductibles, even when you're
talking about a $2,000 deductible. The share of expenses that
you have at the bottom, that you're saying that people are
going to spend out-of-pocket through the HSAs, is a small share
of expenses.
Even if you're able to conserve a bit on that small share,
what is the real extent of the savings going to be to the
system? I would suggest that it would be relatively small.
I agree that time will tell, but I do feel like we're
directing our energies in the wrong direction and away from the
most vulnerable populations.
Senator Reed. Let me ask a followup question: My
understanding--and you can clarify it if it's wrong--is that
someone can have an HSA account, but as soon as they reach the
age of Medicare, they can go into the Medicare system.
I would assume, since there is a certain correlation
between health and age, that the real costs come at the point
where we're actually picking up the tab through the Medicare
system on many of the costs, so that these savings, these cost
containment issues, as you point out, Dr. Blumberg, with a
healthy 35 or 45 or 55-year old, are not the places where the
real, the major cost are incurred in the system. Is that fair?
Dr. Blumberg. Well, I would not go quite there, because
there are sizable costs associated with those under 65, and the
distribution of expenditures there is just as skewed as you see
among the elderly.
We do have very high-cost individuals who have not reached
Medicare age, whose needs need to be addressed. But, clearly,
cost containment is an issue, not just for the elderly, but the
non-elderly, as well.
Senator Reed. Thank you. Mr. Closs, I was very impressed
with the ingenuity and the logic of your business plan, which
raises the question, why don't insurance companies do this
themselves? Why do they need sort of an intermediary like
yourself?
Mr. Closs. Great question. I think there are a couple of
reasons: The first one is antitrust, because, you know, one of
the things, when we get two insurers together, if we're going
to move premium dollars around, right, we want to make sure
that that is absolutely protected, such that particularly when
it comes to pricing, that we want those insurers to compete
aggressively for the employee in that employer group, such that
we want each carrier to present prices based on that group, to
try to get as many members as they can, again, trying to drive
competition in there.
Two carriers together can't really coordinate that up-front
effort toward the sales process and the pricing process. It's
important to have an intermediary in there that protects that
information, and we act as essentially a market-maker to keep
that intact and to promote competition.
More importantly, after the fact, after people enroll,
making sure that each carrier gets the appropriate amount of
dollars. Neither carrier is going to trust each other to
reallocate money to one another, so it's important to have that
person behind the scenes, after the fact, to make sure that the
premium dollars get to the right carrier.
Senator Reed. Thank you. Recognizing that the legitimate
goal of an insurance company is to make profits for their
shareholders or for their members, if it's a mutual
organization, is there a distinction in the profitability of
these Health Savings Accounts? I mean, have we seen that data
anyplace?
Mr. Closs. I'm not aware that there's any data yet that
would demonstrate that. I think it's too early.
Senator Reed. That's a quantitative issue that we haven't
seen. I guess the other question I would have to the panel and
to Mr. Closs, is--and this, I think, goes to the question we've
been addressing all afternoon. What is the chief factor in
changing the profitability of a Health Savings Account? Is it
essentially making sure you pick healthy people, or is it
something else?
Mr. Closs. Well, I would argue that in a risk-adjusted
environment, it doesn't matter whether it's a healthy or sick
person. If the carrier has an incentive to pick the healthy in
the non-risk-
adjusted environment, of course, there are going to be excess
profits, potentially generated from taking the healthy.
But if you're actually putting an environment in place
where they're competing and they know they're going to get paid
appropriately for the risk, it takes that dynamic out, so if
they get a sicker person in that HSA high-deductible plan,
they're going to get more revenue that goes with that to take
care of that person.
Senator Reed. OK, Dr. Blumberg.
Dr. Blumberg. I would just want to put a caution on what
Mr. Closs said, in that I would agree with him in a perfectly
risk-
adjusted environment, but our technologies are not perfect for
risk adjustment. In fact, the best available that's being used
now, I believe, by your corporation and also by the Medicare
Program, can get us to roughly half the theoretically
explainable portion of the variation in expenditures.
Yes, it's true that the profitability of selecting risks
goes away in a perfectly risk-adjusted environment, but nobody
has that at this time.
Dr. Pauly. May I make a comment on the virtues of
imperfection, which, of course, is the old maxim that you don't
want to make the perfect the enemy of the good. We have got
some insights into this question by interviewing the benefits
managers of large firms, actually some years ago, asking them
about medical savings accounts.
It was kind of interesting. They sort of fell into two
camps: The slightly smaller camp were a set of people who said,
``We are terribly worried about adverse selection and risk
adjustment and we don't think we'll offer it, or we'll go
slow.''
Another group said, we tried to offer any benefit plan that
a sizable fraction of our employees like. We said, ``Well,
aren't you worried about risk segmentation,'' and they said,
``Well, no. For one thing, we can pretty well control that the
total amount of difference in well being is pretty small,
relative to our worker wages, and although the young workers
might gain from the spending account in their health insurance,
they're losing on the way we do pensions, without vesting the
pension.'' In some ways, the sort of theoretical idea that
you'd like to make things turn out perfectly, was trumped by
the view that our primary role here in offering benefits is to
offer a variety of things that our workers like, and not worry
about small gains and losses, especially when they are more
potential than actual.
If they turn out to be larger than small, the world--well,
life is long and you can re-adjust things later.
Senator Reed. Thank you very much.
Dr. Pauly. In fact, a lot of firms do.
Senator Reed. Thank you, Doctor. Thank you, Mr. Chairman.
Chairman Bennett. Thank you very much. Having been an
employer and wrestled with these challenges before I came to
the Senate, I'm resonating with what you're saying, Dr. Pauly.
We had a cafeteria plan in which we said to each employee,
``You have $300 a month in what we called `flex box.' You can
spend them any way you want.''
It was a fascinating kind of experience to discover the
different situations with different employees. One employee
said, ``Are you nuts? I've got six kids--and Dr. Cardon, you
may have only two, but I have six--I've got to have every one
of those dollars in a health plan, in order to cover what might
happen if a kid falls out of a tree, rides a motorcycle,
whatever all else. Yeah, I'm healthy, but all that money has to
go to a health plan.''
The next employee comes in and says, ``My husband works at
Hill Air Force Base. He's covered by the Federal employee
program. A health insurance program in this company would be
redundant to the coverage that I already have through my
husband, so can I use that money for daycare?'' We said,
``Sure, you know, give us the name of your daycare provider,
and we will send that money every month to your daycare
provider.''
Next employee comes in and says, ``My husband works at
Kennicott, same thing, I don't need health care coverage, it
would be redundant for me. My kids are all grown. Can you put
that money in my 401(k)?'' Yeah.
And so on. Interestingly enough, the benefit administrator
who ran our plan said: ``Don't offer life insurance. Life
insurance is a bad investment. It's a bad mistake; don't offer
it.''
I said, ``We're going to offer it.'' Well, we just told you
it's a bad mistake. I said, ``That's your determination. There
may be employees who make a different determination, who may
feel, for whatever reason, they want their benefit dollars in
life insurance.''
He said, ``Well, they're making a mistake.'' I said, ``I'm
not going to make that decision for them; I'm going to allow
them to make the decision.'' There was a small percentage of
our employees who said, ``If I have this much--these many
benefit dollars to spend as I see fit, for my piece of mind, I
want some life insurance.''
Their determination of what amounted to peace of mind was
different than the administrator's determination as to what
amounted to peace of mind. I trusted the individual employee to
make that decision, even though I might not have counseled them
to buy life insurance.
It produced a much happier employee and a much higher level
of employee morale, which is, after all, what I wanted. You
know, I offer benefits in order to get people to come to work
for me, and in order to make them feel like they want to stay
working for me, instead of going off to work for my competitor.
I offered them a package of salary, and I offered them a
package of retirement, and I offered them a package of
benefits. That's what you do as employers, you compete in the
pool for the best employees you can get, and then you act in
ways that will hang onto them. You don't want to punish them or
drive them away.
It was a very interesting experience to go through the
cafeteria plan and discover how different people had different
ideas, and, frankly, none of them struck me as irrational.
Everyone had reasons for wanting what they wanted, and everyone
came from a different situation and different circumstances.
The vast majority, of course, spent most, if not all of
their benefit dollars for health care, but there were these
other examples of people who said, ``In our situation, it makes
more sense.'' That experience convinced me that the old canard
that the average person is incapable of making an intelligent
decision with respect to health care, is just that; it's a
canard; it's not the truth. I think we're smarter than many
policymakers give us credit.
This has been a very helpful panel, in helping us
understand the benefits, the opportunities, the challenges, and
the pitfalls of expanding a degree of consumer choice with
respect to health care. I thank you all for coming, and I thank
you all for your contributions. Your full presentations will be
in the record, and based on what we've seen at some of these
other hearings, you'll be read by some very interesting people
that you might not have anticipated when you made your
submission to the Committee.
Again, thank you all. The Committee is adjourned.
[Whereupon, at 11:20 a.m., the hearing was adjourned.]
Submissions for the Record
Prepared Statement of Senator Robert F. Bennett, Chairman, U.S. Senator
from Utah
Good morning and welcome to our hearing on consumer choice in
health insurance. Many consumers would like to have greater choice and
control of their health care and health insurance coverage. They know
from their experience with many other types of goods and services that
choice and competition helps match their different tastes and
preferences to those options providing the best value.
Recent efforts to increase consumer choice include:
providing multiple health plan options with employer-
sponsored coverage,
offering new consumer-driven health care arrangements such
as Health Savings Accounts,
reforming Medicare financing to strengthen private plan
alternatives in what was originally called the Medicare+Choice program
back in 1997, and was changed to Medicare Advantage in last year's
Medicare Modernization Act, and
trying to level the playing field for those purchasers who
select individual insurance market products rather than employer group
insurance coverage.
To be fair, some of those initiatives have advanced further than
other ones. In part, that's because various plans to increase consumer
choice in health insurance often face criticism that they will trigger
a host of purported dangers, usually starting with what's called
adverse selection. That term tends to be loosely defined and widely
used in health policy debates. Its most accurate definition is when
consumers know significant private information about their expected
expenses that their insurers do not know. In that case, it's more
likely that insurance buyers who know that their risks are greater than
average will want to purchase more insurance when it's priced based on
average risk. Buyers who expect their risks to be lower than average
will prefer less insurance coverage.
This simple description of adverse selection then projects that
insurance premiums for the original coverage offered will increase more
than otherwise, because low risks either switch to other types of
insurance or, in the extreme, drop coverage entirely. The end result is
presumed to trigger a ``death spiral'' of rising claims costs and fewer
paying customers to finance them under the initial insurance policy. In
the worst-case scenario, the death spiral extends to the overall health
insurance market, which can break down completely.
Those who believe that more consumer choice in health insurance is
just another risky scheme are likely to handicap it, if not prohibit
it, through such policy measures as community rating, standardized
benefits, coverage mandates, and preferential subsidies.
Today's hearing will examine how employers and insurers can offer
better choices to consumers in practice without producing the sort of
adverse consequences sometimes predicted in theory. We want to
determine what really happens in insurance markets in the pooling and
pricing of risks and sort out real problems from imagined ones. It
appears that there are natural limits on the scope and scale of
potential adverse selection problems. Employers and insurers seem to
manage remaining ones rather effectively in most cases. Nevertheless,
there may be policy opportunities to improve access to the care and
coverage that consumers value most.
Health insurance coverage, of course, is just a means to an end.
The real objective is better health and better, outcomes from medical
treatment. But improving the value of insurance that's available to a
diverse population of consumers is an important part of that process.
Increasing their choices, rather than reducing them, seems to be a
fundamental starting point for upgrading the status quo.
Our panel of witnesses today includes Dr. Mark Pauly, one of the
nation's leading health economists from the Wharton School at the
University of Pennsylvania. He has written extensively about the
operations of health insurance markets and how public policy may shape
them.
Dr. James Cardon of Brigham Young University has examined whether
consumers have private information advantages over insurers that could
trigger adverse selection and distort health insurance markets. His
most recent research focuses on the effects of new consumer driven
health care choices like Health Savings Accounts.
Jeffrey Closs is president of BENU a company that provides benefits
choice center services to mid-sized employers. BENU uses risk
adjustment tools to encourage insurers to compete more vigorously for
portions of an employer's business and provide more meaningful choices
for covered employees.
Linda Blumberg of the Urban Institute has studied issues of risk
selection and risk segmentation in voluntary insurance markets,
particularly those involving small employers and individual consumers.
__________
Prepared Statement of Senator Jack Reed, U.S. Senator from Rhode Island
Thank you, Chairman Bennett. I want to thank the Chairman for
holding today's hearing on the issue of ``adverse selection'' in health
insurance markets. This is obviously an important issue given the
amount of attention that has recently been given to high-deductible
health plans, such as Health Savings Accounts (HSAs).
This hearing gets to the heart of the debate over HSAs, which is
whether or not they will encourage healthy and wealthy people to opt
for higher-deductible plans, while less healthy people are left in
increasingly expensive traditional insurance plans. Unfortunately,
illness affects everyone, regardless of age, race or economic status.
Since HSAs appeal to a healthier population with fewer health care
costs, they could actually have negative consequences for less-healthy
people seeking insurance. The clear danger is that HSAs will divide the
insurance market between healthy and less healthy people, making the
health care system even more inequitable than it is today as insurers
adjust pricing to reflect the risk pools in each type of insurance.
If HSAs attract the healthiest people, those Americans with
traditional insurance will face higher premiums and increased cost-
sharing. Higher premiums will put tremendous pressure on companies to
stop offering comprehensive, traditional insurance. Companies will
either pass on the higher costs to employees, make them switch to an
HSA or simply drop coverage. While proponents of HSAs argue that they
offer consumers more choice, those may not be terribly attractive
choices to many people.
President Bush has proposed spending $41 billion on HSAs and high-
deductible plans, which will at best extend health insurance to a tiny
fraction of the 44 million who don't have coverage today. Clearly, this
policy is not directed toward insuring the uninsured. It looks more
like HSAs are another tax shelter for the wealthy--who have no trouble
affording insurance or quality health care--rather than an innovative
approach to expanding health care coverage.
I'm skeptical of the benefits of HSAs, which probably won't reduce
costs or increase health coverage. Nevertheless, I hope today's hearing
will shed some light on whether or not HSAs will make it easier for
patients to get the care they need.
__________
Prepared Statement of Mark V. Pauly, Ph.D., Bendheim Professor,
Professor of Health Care Systems, Insurance and Risk Management, and
Business and Public Policy in the Wharton School, and Professor of
Economics in the College of Arts and Sciences, University of
Pennsylvania
Thank you, Mr. Chairman, and members of the committee, for an
opportunity to testify on adverse selection in health insurance and
related issues.
Private health insurance would be far less controversial if we
lived in a world where everyone was similar in terms of risk. Then
insurers would charge similar premiums to everyone who put similar
effort into shopping for a given policy, and would be equally eager to
sell insurance to anyone. After the fact, those lucky enough to have
low actual health expenses would have paid in more than they got back
from insurance, but this redistribution from those who did not become
sick to those who did would be something that everyone would agree
before the fact was both fair and attractive, and all would be eager to
buy insurance as long as the premium was not too much higher than
expected benefits.
The world in which we do live, it is obvious, is different. It is
one in which ``risk'' varies before the fact, in the sense that
different consumers reasonably expect to collect different amounts in
benefits from a given policy because they expect to get sick with
different frequencies and severities. Insurers can identify and measure
some characteristics that they know predict above or below average
benefits, characteristics such as age, location, and the presence of
chronic conditions. Insurance markets can still function in such a
world, but now either premiums or purchases will be different for
different people.
What will happen depends crucially on whether insurers have and can
use the same information that predicts benefits as consumers can use.
If everyone has the same information, and the information does predict
different risk levels, then insurance theory (Rothschild and Stiglitz,
1976) tells us that insurers will choose to charge below average
premium to the lower risks and above average premiums to the higher
risks. Someone who has four times the expected benefits from a given
policy compared to someone else will be charged about four times the
premium. At those premiums, insurers will be equally eager to sell to
low and high risks. In insurance theory, this situation of proportional
risk rating will be stable and probably will be one in which low risks
are no less likely to buy insurance than high risks. (Some very high
risks with low incomes may find that premiums are so high and expenses
so near certain that they are just as well off not buying insurance
they cannot afford and paying those expenses directly when and if they
can.)
Insurance markets, the same theory also tells us, will be very
different if insurers do not have equal information to what buyers
have, or if insurers are not allowed to use the information they do
have in setting premiums and bidding for business. In the extreme case
in which insurers either cannot distinguish among risks or are not
permitted to do so, they will be forced to charge the same premium to
everyone who buys insurance. But if the insurance purchasers know their
risk levels, their willingness to buy insurance at this premium will
vary. Higher risks will be very enthusiastic about buying, since they
can on average collect in benefits more than they pay in premiums. But
low risks may, in the limit, decide not to buy insurance at all because
it looks like a bad deal to them, or may at least seek to buy less
generous coverage than the high risks desire. This situation of
community rating will be one in which the low risks are less likely to
buy insurance than under risk rating. In the limiting case in which the
low risks bail out altogether, the so-called death spiral, the premium
insurers end up charging to the high risks will be the same as they
would have charged under risk rating; the effect of community rating
will only be to drive out all of the low risks (which is definitely not
the same as no risk) from the insurance market, with resulting adverse
effects on access to care and financial stability. It is in this sense
that community rating can be inefficient compared to risk rating, since
it can make the low risks worse off and not make the high risks better
off (Pauly, 1970). In the less extreme case in which some low risks
might continue to buy, the high risks could be better off but the low
risks will still be worse off than they would have been under risk
rating. There will still be inefficiency compared to the ideal because
the low risks will choose less coverage than they would have chosen if
they had faced premiums reflective of the true cost of their coverage.
Whether there will be cream skimming, in which insurers are more
eager to sell to low risks than to high, depends on whether the adverse
selection-community rating is essential (caused by insurer inability to
tell risks apart) or inessential (caused by regulations or policies
which forbid insurers from using information they have to set lower
premiums for lower risk and higher premiums for higher risks). In the
case of essential adverse selection, as in the case of risk rating,
there should be no cream skimming because all potential purchasers look
equally profitable to insurers. Insurers might want to cover only the
low risks, but they cannot tell who is who. In the less extreme case of
regulation-required community rating, insurers will try to avoid
selling to high risks they can identify, on whom (as a group) they are
sure to lose money; there will be cream skimming.
For these kinds of reasons, some insurance analysts think risk
rating is better than community rating. But many policymakers, and some
other analysts, do not look at it that way. They do note the downside
of community rating in terms of squeezing out the low risks, even to
the extent of a death spiral in which at some point only the highest
risks end up buying. (This should really be called a near-death spiral
because at that point it will be profitable for some insurer to enter
and offer a less generous plan at a much lower premium that can pull
some of the lower risks back into the market; the market will rise,
phoenix-like, only to go into another spiral.) But policymakers also
find much not to like in risk rating, precisely because the higher
premiums for higher risks may bite into their ability to consume other
necessities for life if they have low income, and sometimes because
observing higher income high risks paying more than higher income low
risks still looks unfair, especially compared to a policymakers' dream
world in which everyone pays a low premium. That this is impossible in
a world of competitive but unsubsidized insurance markets only
marginally dampens their ardor.
The most obvious way to deal with these problems is to use
regulation. Require insurers to charge similar premiums (or limit
premiums for high risks), but forbid low risks from buying less
generous policies. Then require insurers to sell policies to high risks
they know will be causing losses, and, when there is enough political
nerve, forbid insurers and the low risks from dropping out by mandating
insurance purchasing. Measures short of this draconian one can still
lead to bad adverse-selection type outcomes, especially when community-
rating rules force insurers to ignore information they have and thus
lead to inessential adverse selection. Then, when insurers respond to
community rating regulations with cream skimming, one needs to write
yet more regulations to require open enrollment and guaranteed issue.
To avoid the death spiral, we move to a regulatory spiral. As with
other kinds of health care regulation, how bad (or good) the regulatory
outcome will be seems in practice to vary across states, depending on
the characteristics of their potential insureds and the form and
administration of the rules. In some states such rules seriously
curtail the size of the insurance markets, while in others the main
effect is only discontent among the low risks and the insurers who
would like to sell to them.
The main novel point I want to make here is that recent research
suggests that, in both theory and practice, there are ways alternative
to regulation to get closer to what policyrnakers want (or should want)
when risk rating and adverse selection are possible. Compared to
perfect regulation administered with perfect regulation, or even to the
wise and prudent regulation that occasionally happens, these
alternatives may still leave something to be desired. But compared to
the kind of regulation we have had or can generally expect to have,
they at least deserve equal billing and equal consideration. These
alternatives may work better if some other government actions are
curtailed and some modest regulation applied to encouraging the
alternatives.
To be specific: one might suppose that, as is often the case,
policymakers must choose between two undesirable outcomes--unfair risk
rating or inefficient community rating--in order to deal reasonably
well with risk variation. New developments in research (Pauly,
Kunreuther, and Hirth, 1995; Cochrane, 1995) suggests that, in theory
and in fact, in many circumstances realistic competitive insurance
markets can avoid much of both bad situations, and that a relatively
modest amount of public intervention can deal with the cases that fall
through the remaining cracks. The fundamental reason for this market
behavior is that potential insurance consumers also dislike the more
negative aspects of either kind of behavior, and competitive insurers
have developed methods to avoid them. The fundamental reason for the
political behavior is that some policymakers have already developed
some well-tailored solutions that leave the market intact but rein in
the worst cases.
The three kinds of ``solutions'' to which I want to draw your
attention are (1) guaranteed renewability at uniform premiums, (2)
group insurance, and (3) high risk pools. Because the first is much
less well understood than the other two, I will discuss it in more
detail, but I will also comment on the other two devices.
The great majority of people who are high risk today were not
sicker than average at all times in their lives. Data shows what common
sense tells us: even people who are in excellent health have higher
medical expenses on average as they age, and some pick up chronic
conditions. The age-related part of increasing risk is perfectly
predictable; what is not predictable is the random onset of a chronic
condition that makes a person high risk not only initially but for some
time to come, possibly for life.
Most medical expenses for people under 65 are not related to
chronic conditions; they come from the ``bolt-from-the-blue'' event of
an accident, a stroke, or a complication of pregnancy that we know will
happen on average but whose victim we cannot (and they cannot) predict
well in advance. This is precisely the kind of low probability, high
cost event for which insurance works extremely well as a device for
substituting a smaller certain payment for an unexpected rare but large
payment. Sometimes, however, what strikes unexpectedly is a condition
from which the person is unlikely to recover rapidly; such random but
then chronic conditions make future medical expenses higher for people
who have them. If insurance premiums were proportionately risk rated to
the risk prevailing for the next year (the usual time period for health
insurance), people who are well today and have no chronic conditions at
the moment would face the chance of contracting such a condition with
two bad financial outcomes. Not only is diagnosis usually associated
with high immediate medical expenses, it would also be associated with
a sudden and serious jump in premiums.
Risk averse people should want to have protection not only against
high current period expenses but against the unexpected onset of a
condition that might entail high lifetime premiums; they would seek
protection against ``the risk of becoming a high risk.'' In some real
world health insurance markets such protection exists and was quite
common even in the absence of regulatory rules. Specifically, most
health insurance policies bought on an individual basis contained a
provision also common in individual term life or disability insurance:
guaranteed renewability at class average premiums. With this provision,
the insurer promises not to single out insureds whose risk has
increased more than average for high premiums when they renew their
coverage. Instead, they are to be charged the same premiums as are
charged to everyone else who was in the same initial (usually low) risk
class as they and bought the same type of coverage. Administering such
a guarantee is easy for an insurer: it promises to base its future
premiums only on whatever information it collected about risk when it
initially sold the coverage; it promises not to revisit the question of
risk based on new data that might be obtained from the person or even
based on the claims history data that the insurer has; it promises not
to ``re-underwrite.'' This provision does not guarantee constant
premiums; premiums can rise if expected medical expenses rise for
everyone in the risk class (say, because of higher medical prices), and
premiums may rise according to a schedule specified in advance as a
function of perfectly predictable things, like growing older. But the
person with coverage with this feature is protected against the bad
luck of becoming riskier than average, and therefore will not pay a
higher premium on becoming a high risk. This feature is not free, of
course; policies that contain it must have higher initial premiums
(``frontloading'') than would premiums for a policy for which the
insurer retained the right to increase premiums for people who
contracted a chronic illness. But it is easy to see why rational,
foresighted people would prefer the slightly more expensive but surer
policy to the cheaper but riskier one.
Federal law now requires states to ensure guaranteed renewability
for individual (but not group) insurance policies. But even before the
spread of such State laws, industry observers estimated that about 80
percent of policies voluntarily (on the parts of both buyers and
sellers) contained such provisions. (Pauly, Percy, and Herring, 1999)
There is, however, considerable debate about how they work in practice,
debate which is assisted by the absence of nationwide comprehensive
data on practices in insurance markets, especially in the individual
market, so that evidence tends to consist of anecdotes and problematic
surmises. There certainly have been cases in which insurers were caught
engaging in re-underwriting even when they were forbidden to do so, and
a number of State insurance departments have said that they would
prohibit risk rating at renewal even in the absence of specific State
law under their general authority to limit arbitrary and excessively
discriminatory premiums (Patel and Pauly, 2003). Some insurers are said
to have gotten around the requirement to continue to cover high risks
by raising premiums for all insureds so that all drop out of the risk
class, and then selectively re-enrolling only those low risks who have
not been put off by this behavior. Insurance brokers and agents insist
that they pay attention to this kind of behavior and steer customers
who come to them for advice away from insurers who engage in semi-shady
practices. We know that this feature does not work perfectly everywhere
for everyone, but how well does it work on average?
Research has provided some data that is highly consistent with
guaranteed renewability generally operating as the theory and the
intent of the contractual provision suggests (Pauly and Herring, 1999;
Pauly and Herring, 2001). This finding is striking enough that it
deserves to be emphasized even beyond the issue of guaranteed
renewability. To be specific, there is very strong empirical evidence
that the premiums higher risk insureds pay are much lower than would be
consistent with proportional risk rating. Stated slightly differently,
while high risks do pay higher premiums than low risks, the increase in
premium with risk is much less than proportional to the increase in
risk.
This result has been obtained in a large number of studies using
large nationwide data sets from different time periods. Depending on
the measure used of risk, the ``elasticity of premiums with respect to
risk'' in multivariate analysis of data ranges from about 20 percent to
less than 50 percent; never higher. That is a person whose risk is
twice as high as average will pay a premium only 20 percent higher.
Table 1 shows more intuitive evidence for this proposition. It uses
data from the late 1980's before there was widespread premium
regulation in the individual insurance market or requirements of
guaranteed renewability, but when that feature was common nevertheless.
The risk level for a person in the data set is characterized by the
person's age, gender, location (to measure differences in medical
cost), and pre-existing chronic conditions. Statistical models were
used to relate the actual medical expenses, and the actual insurance
benefits received for each person, to that person's values for these
variables; the estimate of risk for that person is then the ``predicted
value'' of their medical expenses (that is, the average medical expense
for a large number of people with the same values for these
characteristics as they). Those risk estimates were then used to select
a sample of people with individual health insurance expected to have
medical expenses in the top 10 percent of possible values of risk, and
another sample of people in the bottom half of those values. As the
first line of the table shows, the expected expenses, the actual
average expenses, and the actual average insurance benefits were much
higher for the high risks than the below-average risks. The average
benefits for the high risks were 11 times greater (at $2054 per person)
than for the lower risks (at $187). The premiums were higher for the
higher risks too, but the key point is that the premium for these very
high risks (at $1150) were only 1.4 times greater than that of the low
risks ($825); there was a substantial amount of averaging of risk in
the premium structure.
While there are doubtless many causes for this phenomenon, one of
them probably is guaranteed renewability. People with such provisions
would not be paying premiums that were higher than average because they
became higher risks. Of course, some people in the data were new
purchasers of insurance whose premiums would be risk rated, but
apparently by no means all. There is even stronger evidence. We looked
at how premiums and risk varied with age for similar policies. Insurers
certainly can determine a buyer's age, and they certainly can determine
that, other things held constant, expected expenses and benefit
payments will rise with age (especially for men). What we found,
however, was that the premium paid by the average older man was only
about 40 percent higher than that for the average younger man when the
expected expenses differed by a factor of two to one. But this pattern
of overpayment relative to expected expense for the younger people who
would generally be the new buyers of insurance is exactly the
frontloading that would be predicted to arise under guaranteed
renewability (but that would be unstable in competitive insurance
markets under proportional risk rating). We have further examined the
path of premiums and benefits with age in this market and find that it
corresponds rather well with the path that would be consistent with
guaranteed renewability. In doing this analysis, we adjusted for the
fact that people often do not keep their individual coverage from a
given firm but drop it because they have taken a job that carries
coverage or because they switch insurers. Because the low risks have
already prepaid their contribution to the high risks, their dropping
out does not cause any problems for the ability of insurers to continue
to maintain protection for higher risks. Some high risks do drop out as
well but, as expected, at a much lower rate.
In our analysis of individual insurance data we found that only the
locational and demographic variables were consistently related to
higher premiums. The person's health status when they bought insurance
(measured by the presence of a pre-existing chronic condition) was not
statistically related to premiums, but the scarcity of observations on
people with such conditions means that our estimates are themselves
necessarily imprecise (Jack Hadley and James Reschovsky, 2003) using a
different risk measure (contemporaneous health status) and a more
sophisticated but somewhat delicate statistical technique, did find
that people in poorer health paid higher premiums, but even there the
increase in premiums was much less than the increase in risk. I
therefore conclude that individual insurance markets (even when they
were unregulated) provided a substantial amount of protection against
the adverse effects of risk rating to people who did what we want them
to do--bought insurance before they became high risks, and stuck with
their insurance rather than becoming uninsured.
Risk rating can only occur if insurers can determine risk levels;
under perfect risk rating, there can be no adverse selection. However,
in a world in which buyers of insurance may sometimes know more than
sellers, it is interesting to note that guaranteed renewability
provides potentially important protection against adverse selection. If
people buy this coverage early in life (as they should to take
advantage of the provision), they are likely to be much more similar in
risk levels than they will become later on. And since it is rational
for the people who remain healthy to stay in their original policy
where they have already made transfers to those in their cohort who
became higher risks, it is less likely that they will drop out and
start a death spiral. Finally, if those who remain lower risk do drop
out or are lured away, because they have already prepaid their transfer
to the high risks, the insurer does not need to raise premiums to the
high risks.
We have investigated some of the other reasons why higher risks pay
premiums that are less than proportional to their relative risk levels.
There is evidence that higher risks search more intensively to find a
premium that is low relative to the expected benefits; it makes more
sense to checkout many insurers (or use a broker to do so) when one is
paying $400 a month for insurance, than when one is 25 and paying less
than $100 a month for insurance (Pauly, Herring, and Song, 2003). And
it probably is true that some risk factors, like the decision on the
timing of the next child or the repair of an old football injury, is
better known to the insured than to the insurer. But this phenomenon
may be partially offset by the fact that insurers actually have more
accurate data on risks than typical insurance consumers do.
Another feature of insurance that can protect against uncertain
jumps in premiums and adverse selection is group insurance. The great
bulk of Americans obtain their health insurance as group insurance
related to their employment. Probably the main reason they do so does
not have to do with any risk variation factors, but rather to the
substantial tax subsidy to workers (not to employers) present in the
exclusion of compensation received as health benefits from income and
payroll taxation. But group insurance probably does have some features
that deter the kind of behavior theory was earlier said to predict.
Most simply (but not most obviously), group insurance offers a much
better deal for your money for a given policy than does individual
insurance. The difference between the premium one pays and the benefit
one should expect on average to get in group insurance is lower than
for individual insurance both because of economies of scale associated
with group purchasing (especially lower selling and billing costs) and
because of the tax subsidy. These features in effect may make insurance
such a good deal for the wealthiest low risks (who get the biggest tax
subsidies) that they will not be motivated to drop coverage and start a
death spiral even if their premium is not properly tailored to their
risk. As long as a low risk's net premium is low enough after the tax
benefits are taken into account, the fact that there is some cross
subsidy to higher risks may not matter.
A more complicated issue is whether or not employment-based group
insurance in some sense ``pools risk'' more than other arrangements.
For large groups, there is no explicit individual underwriting, but the
cost of that function is only a tiny fraction of any insurer's
administrative cost. There can be variation in premiums with risk
across small groups; a firm of three 25-year-olds in good health will
pay much less than a firm of three 60-year olds who are out of shape.
Moreover, the requirement that one be able to work to qualify for one's
own employment based insurance serves to automatically screen out the
highest risks and those unable to take a job because they are caring
for a dependent with high risk. But the key determinant of access to
insurance and net payments for insurance is the policies employers
follow with regard to this benefit:
One thing that employers are motivated to do is to try to keep as
many of their employees in the insurance plan as they can, because the
premium, or even the availability of group insurance, depends on the
participation level of workers in the firm. Let too many of them drop
out, and the group insurance may not be offered by an outside insurer.
Even self-insured employers (who cover the majority of workers
nowadays) want to achieve economies of scale. Thus employers should
want to avoid death spirals and widespread non-participation.
Probably most importantly, workers in group insurance almost never
pay an explicit total premium that is related to their precise risk
levels; they almost always all pay the same employee premium if they
choose the same policy for the same-sized household unit. (There is
explicit risk rating for the higher risk associated with having more
people covered under a family policy relative to an individual policy).
However, economists believe that workers pay for the bulk of their
group insurance not through explicit premiums but through lower wages,
and generally money wages are not explicitly adjusted based on an
individual employee's risk level.
The evidence does, however, strongly suggest that worker wages are
adjusted to some extent to reflect the different cost of insurance as a
function of risk (Pauly and Herring, 1999; Sheiner, 1994). Wages vary
by seniority, and more senior workers are usually older. What we found
was that, other things equal, wages increased significantly less
rapidly with seniority for workers who obtained job-based insurance
than for those who did not; we interpret this as the effect of higher
insurance costs taking away some of what would have been the usual
raise associated with more experience and seniority. Moreover, common
sense tells us that an employer cannot take the typical $6000
``employer contribution'' out of the wages of younger workers and still
expect to compete to hire those workers with other firms that offer
higher cash wages and no coverage.
There is no evidence that wages vary with health status given age
and gender (though the lower wages of women could in part reflect their
higher medical costs). But remember that with guaranteed renewability,
premiums in individual insurance also need not vary with health status.
Thus I would conclude that the amount of risk pooling in group
insurance is at best only very modestly greater than in individual
insurance on average. The difference would be greatest between a high
risk person able to get a job at a firm that offers benefits and what
that person would be charged as a new applicant for individual
insurance. But the job with insurance is by no means assured to a high
risk, and the typical buyer of individual insurance is renewing, not
buying new, so this difference tends to average out to a small number
if it is present at all.
The main virtue of group coverage in terms of risk variation is not
risk pooling per se but rather that it discourages adverse selection.
It does so in several ways. Most obviously, the range of insurance
choices a person has within a firm is usually much smaller than the
range of choices in individual insurance, and any opportunity to choose
less generous coverage (whether it is a high deductible plan or a cost
constraining HMO) offers a chance for low risks to separate themselves
out. The downside of this advantage is less choice, but firms and their
workforces are free to make this choice not to have many choices.
Equally, if not more important, is the fact that the worker who
chooses to decline group insurance while remaining in the firm almost
never recaptures the full premium for that coverage. Instead the worker
will get back any employee premium and (in some firms) a small bonus
for refusing coverage, but that reward is almost always much less than
the value of the insurance even to a low risk. We do have a problem
with more workers offered employment-based coverage rejecting it,
especially as the average explicit employee premium has risen, but
there are almost no cases where rejecting coverage to save the employee
premium would be rational behavior if the person thought that without
coverage they would have to pay for all of their medical care out of
pocket. (They might drop and expect to rely on family assistance or
charity care, and the still tiny fraction of people offered coverage
who reject it may just be the minority of any population who are
irrational or unthinking.)
So there is very little total dropping out by lower risks, but do
they inefficiently drop back to less generous coverage? Not
necessarily, because employers can if they wish control adverse
selection and risk rating. The simplest way to do this is to offer only
one plan. But even when employers offer several plans, the key to
controlling selection is to properly set the difference in employee
premiums (or in the contribution to spending accounts) across plans
(Cutler and Reber, 1998; Pauly and Herring, 2000). If employers
foolishly make the premium much lower for the less generous plans, then
all but the highest risk will join them, leaving the few remaining high
risks in a more generous plan. But research shows employers how to
calibrate the premium difference to reflect the premium cost reduction
associated with the low risks (not the average and certainly not the
difference in expected benefits when the low risks have already sorted
into the less generous plan). So employers who want to control adverse
selection can do so to a considerable extent (though not perfectly),
especially if they self insure all of the plans they offer. Things are
somewhat more complex if multiple outside insurers are used and those
insurers are not given the data they need to estimate the risk levels
of the people who will choose their plans. Risk adjustment of the total
premium the insurer gets combined with appropriate setting of premium
differentials will prevent adverse selection if that is an employer
goal.
Research (Pauly, Percy, Rosenbloom and Shih, 2000) suggests that
some employers try to limit the choice of options and set the premiums
to control adverse selection, while others take the view that any
redistribution away from older workers in their health plan offering is
probably offset from redistribution toward such workers in their
pension plan or in other benefits, and that the total amount of
redistribution (and inefficiency) is small. As long as the least
generous plan offered is still a decent plan even for higher risks,
there probably need be little policymaker concern about adverse
selection in group insurance. Personally I would only be concerned
about offering a health savings account type plan to very low income
workers, or offering a very restrictive HMO to workers who would react
strongly to limits on access, but I would not be much concerned in
general.
How does the rate of takeup of insurance vary with risk level in
group and individual insurance? Are higher risks more likely to have
coverage than lower risks (which would be consistent with adverse
selection), are they less likely (which would be consistent with very
strong risk rating), or is coverage nearly universal and independent of
risk (which would be ideal)?
Research on this subject is far from definitive. Studies that have
looked at people in households where someone is a full time employee
(and therefore potentially eligible for group insurance if the person
chooses or is able to get a job at a firm offering coverage), the
strongest and most consistent finding is that the size of firm in the
industry or occupation of the worker is by far the most important
predictor of having coverage (along with the size of the tax subsidy
and therefore income) (Pauly and Herring, 2000). People who work in
industries dominated by larger firms are much more likely to end up
with coverage than those who work in small firm industries. The
relationship of coverage to risk, given firm size, is less well
understood. What we observe seems to depend on what measure of health
risk we use. If we use chronic conditions as the measure, employed
higher risks are more likely to have coverage than employed lower
risks. If we use self reported health status, coverage may be less
likely for high risks. Analysis of the late 1980's data showed that
high risks were significantly less likely to have group coverage only
if they were low-income people working in small firms, but not
otherwise (Pauly and Herring, 1999). There is little evidence that
employers in general have difficulty in continuing to offer coverage to
people who become high risks, and no evidence at all that they have
problems with people who have unexpected high expenditures.
It is much harder to determine how risk levels affect the
likelihood of having coverage in the individual market because anyone
can participate in that market, but most people do not do so and
instead obtain group insurance. We have looked at people in households
where no one is a full time employee--the household's income comes from
self employment, part time work, or non-work sources. The relationship
here depends even more on the measure of risk. Len Nichols and I (2002)
found that if we measure risk by age, controlling for income, older
people in ``non-group'' households were much more likely to have
individual coverage, despite higher premiums, than younger people. We
also found that people with chronic conditions were more likely to have
coverage, although the relationship was not as strong. On the other
hand, when risk is measured by self-reported health status, people who
label their health as fair or poor are less likely to have individual
coverage controlling for income; this is the opposite of adverse
selection. One puzzle in the data is that many of those with insurance,
who say that no one in their household works full time, still list
themselves as having obtained group insurance coverage; there is no
clean division of the population between those with access to group
insurance and those who must use the individual market.
Precisely for this reason one should be very cautious in trying to
draw conclusions about the comparative performance of individual and
group insurance markets. If I was forced to do so, I would conclude
that there may be differences in the likelihood of obtaining individual
insurance coverage by people who are very high risks when they seek
coverage, but that if the group market does better, the differences are
small, and are limited by the fact that many very high risks do not
have access to employment-based insurance. It would be nearly
impossible to provide those currently without a group option access to
that option on the same terms as the current users. I think the
differences in the extent to which net premiums do (or could) vary with
risk are small, and any stronger relationship in the individual market
is attributable to its small size and marginal or add-on character. For
example, a person who had group insurance, who contracts a high risk
condition, loses their job and insurance, and uses up their COBRA
coverage, will be recorded as a high risk trying to buy new coverage in
the individual market. But one could argue that placing the person in
that situation is as much the fault of the link between tax subsides
and group insurance which does not provide guaranteed renwability
protection to individual workers as it is the fault of individual
insurance.
Fortunately, there is a device available to pick up the pieces
without requiring the imputation of blame: high risk pools. I do not
intend to discuss the actual working of these pools in detail. Instead
I want to point out that the concept of having a subsidized, decent
though limited coverage policy available to high risks unable to obtain
or retain individual or group coverage makes great sense as a safety
net. Since the number of high risks is by definition low, it avoids
having to distort insurance markets for the great majority who are not
high risks in order to make transfers to a few unlucky people. Some of
the more anecdotal research shows that almost any risk can obtain
individual coverage if they persist at searching long enough, but those
who have already been rejected or quoted very high premiums perhaps
ought to have another option than spending their time with insurance
brokers. In idealized concept, a high risk pool ought to offer coverage
at premiums somewhat higher than those charged for good risks but still
at reasonable levels to people who have tried and failed to obtain
coverage on their own. The financing of these pools should be generous
enough to accommodate those who need to use them, and that financing
should be raised by general revenue taxation, not by requiring insurers
to contribute and thus raising premiums which drive more people out of
regular insurance. The terms of coverage (premiums, type of coverage)
should be only moderately attractive, because we want to preserve
incentives to people to obtain voluntary coverage before they become
high risk, rather than wait to pick up attractive subsidized high risk
coverage when and if that happens. I am hopeful that it is possible to
design a plan that walks this fine line and still preserves an
opportunity for people to obtain coverage that will give them financial
protection and access to care. Coordinating high risk pools with
guaranteed renewability provisions would seem to be desirable.
To sum up: the important problems with private health insurance in
the United States are not associated with the risk variation-risk
segmentation issues that are so prominent in insurance theory and many
policy discussions. Our problem is not that the insurance is expensive
and unattractive for high risks; it is that in some cases it is
expensive and unattractive for all risks. It is true that the largest
single segment of the uninsured population is low risk healthy twenty-
somethings, and some adverse selection in group and individual
insurance may modestly contribute to this. But I believe that a much
larger contributor is the absence of generous subsidies and the absence
of marketing efforts targeted at this group; there may actually be too
little effort at cream skimming those low risks who remain uninsured.
This is especially the case for people who are discriminated
against by being ineligible for generous tax subsidies when they buy
insurance (the non-self-employed in the individual market) and those
who could have access to products with lower across-the-board
administrative costs but do not currently have such access. Finally,
the key background issue of what if anything we want to do when
premiums are rising not because of insurance market behavior but
because medical care is becoming both more costly and yet much better
should really be front and center in the policy debate.
Table 1.--Expenses in Nongroup Individual Coverage, by Risk (Expected
Expense)
------------------------------------------------------------------------
Bottom
50% Top 10%
------------------------------------------------------------------------
Actual benefits....................................... $187 $2054
Premiums.............................................. 825 1150
Actual expenses (total)............................... 555 3504
------------------------------------------------------------------------
Source: Pauly and Herring (1999), based on 1987 NMES data.
References
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Impact of Community Rating,'' Federal Reserve Board, December 1994.
__________
Prepared Statement of James H. Cardon, Ph.D. Associate Professor of
Economics Department of Economics, Brigham Young University
Mr. Chairman and Members of the Committee:
I have been asked to comment on the problem of adverse selection,
both generally and as it might apply to consumer-directed health plans,
such as Health Reimbursement Arrangements (HRA), and the new Health
Savings Accounts (HSA).
Adverse Selection is a term borrowed by economists from the
insurance industry to describe a possible problem in the functioning of
insurance markets. Insurance is valuable to people because it allows
them to make a fixed premium payment in exchange for reducing risk.
Adverse Selection is caused not by imperfect information about future
expenditures but by asymmetric information: buyers or sellers of
insurance may have private information about risk. There is potential
for adverse selection any time either buyers or sellers have
significant informational advantages.
George Akerlof (1970) first illustrated the problems of private
information advantages in the used car market, the market for
``Lemons.'' Cars are either good or bad, and only the owners--having
driven them for some time--can tell the difference. Buyers cannot tell
the difference, and will therefore be unwilling to pay a ``Cream Puff
'' price for a car that might be a Lemon. Cream Puff owners are
unwilling to sell at less than Cream Puff prices, but Lemon owners are.
Then only Lemons are sold, and the used car market unravels in what is
sometimes called a `death spiral'. This is great economic theory
because it is simple, intuitive, and seems to be supported by casual
experience. Best of all, it would seem to apply to a wide range of
markets. It is tempting to start seeing Adverse Selection everywhere.
On the other hand, this simple, stylized model ignores important
details of real markets.
Michael Rothschild and Joseph Stiglitz (1976) extended the argument
to the case of insurance. In this case, consumers have private
information about risk status that they withhold from insurers. High
risk consumers cannot be distinguished from Low risk consumers. The
authors identify a simple market solution to this information problem
that effectively identifies and separates High and Low risks. The
insurer offers 2 plans to all customers. One is a high cost, high
coverage plan and the other is a low cost, low coverage plan. Premiums
and coverage levels are carefully chosen so that High risks choose the
High coverage plan and Low risks the Low coverage plan. Risk types are
fully revealed, and the only deviation from a world of symmetric
information is that the Low risk types are forced to accept less
coverage.
A possible alternative outcome involves Pooling of risk types into
a single plan. Both risk types receive the same coverage and pay the
same premium, which reflects the average risk in the pool. Risk types
are not revealed in this outcome. Low risk types subsidize High risk
types and there is potential for an outside firm to engage in ``cream-
skimming'' by offering a plan that only Low risks will prefer. In this
case, the pooling outcome does not occur. Pooling outcomes can and do
exist in the group market, where the possibility of cream-skimming by
outside firms is limited by employer subsidies, tax subsidies, and the
fact that, on average, group insurance is cheaper than non-group
insurance per dollar of coverage. Factors that can limit worker
mobility between firms increase the potential for a pooling outcome,
and Crocker and Moran (2003) show that more generous and comprehensive
coverage is feasible with decreased mobility.
The separating outcome, in which each risk type is correctly
identified and rated, troubles some analysts because superficially it
seems to defeat the risk-pooling function of insurance. This is a
mistake, since health care expenditures are wildly unpredictable even
given detailed information about demographics and medical condition.
Because all risk types face substantial uncertainty about actual
expenditures, insurance with premiums that accurately reflect those
risks will always be desirable. The separating outcome is a possible
market solution to severe informational asymmetry.
SOME LIMITATIONS OF THE MODEL
The model above assumes that consumers have the informational
advantage. This might not be true. After all, insurers have data on
perhaps millions of consumers as well as a reserve of medical expertise
not available to the average consumer. New customers might have an
advantage over insurers, but for the cost of a physical the insurer can
obtain a great deal of information to reduce its disadvantage. It seems
likely that both sides of the market have private information of some
type.
Also, the private information consumers have might be of little
practical use. To be useful the information must be specific about
near-term expenditures. I believe that part of the reason that adverse
selection seems obviously true is that we often mistake vague worries
about family history for reliable information. We probably have less
useful information than we think.
The model assumes that there is a single year of coverage and no
chance for learning over time. Yet many consumers stay with the same
insurance company for years, and claims data are a gold mine of
information on current usage and diagnoses of acute and chronic
conditions that should help insurers identify a consumer's risk type.
EVIDENCE OF ADVERSE SELECTION IN VARIOUS INSURANCE MARKETS
As used and as useful as this model is, there is something of a
divergence between the theory and its application to real markets, and
this has led to widespread misinterpretation of statistical evidence.
There is a crucial difference between selection based on private
information (unobservable information) and selection based on public
information (observable information, including demographics and
income). Theoretical models that lead to adverse selection are
concerned with private informational advantages.
In a paper published in 2001, Igal Hendel and I built a statistical
model to test for the presence and importance of asymmetric information
in health care markets. The question is whether there is evidence of
private information that can produce adverse selection. The test we
used is based on the link between insurance choices and subsequent
consumption of health care. We distinguish between mutually observable
information, such as demographics and income, and information which is
private to the consumer. The unobserved information links insurance
choices and health care expenditures, as those consumers more likely to
need health care purchase more generous insurance coverage.
Intuitively, the test is based on whether the link between insurance
choice and health care consumption can be explained by the observed
information. If observables account for the link, then we can rule out
the importance of private information in the joint insurance/health
care decision.
Much to our surprise, we found that the link between health
insurance choices and health care consumption is mostly explained by
income and other demographics\1\. As is normally the case, expenditures
do vary predictably with income and demographics, but most of the
variation in expenditures is purely random and unpredictable. Our
research shows no evidence of private information leading to adverse
selection in the health insurance market.
---------------------------------------------------------------------------
\1\ One simple numerical measure of the private information is what
we might call a ``signal to noise ratio'', or the ratio of the
estimated variance of private information to the estimated variance of
the purely random component. The higher the ratio, the more important
private information is. The ratio is .27 if we artificially exclude all
demographic variables and .004 if we include those variables. By this
measure, the amount of true private information is trivial.
---------------------------------------------------------------------------
Evidence from related insurance markets can be used to assess the
importance of private information. Two recent studies examine adverse
selection in the auto insurance market. Chiappori and Salanie find no
evidence of adverse selection among new drivers in the French market
(2000). Dionne, Gourieroux, and Vanasse (1998) and find that there is
no adverse selection in the Quebec market once observable demographics
are controlled for.
The life insurance market is similar in many respects to the health
insurance market. There is much at stake for consumers, the underlying
risk is partly health-related, and there exist both group and
individual submarkets. Cawley and Philipson (1999) use data on actual
premiums and quantities as well as consumer perceptions about risk.
They find that, contrary to predictions of the basic model, there is a
negative relationship between risk and the amount of insurance
purchased (people who believe they are at risk purchase less
insurance). They also find evidence of bulk discounting: the cost per
dollar of coverage becomes cheaper for higher coverage. Both of these
findings are inconsistent with private information on the consumer
side. The authors suggest that, in this case, the insurers have the
information advantage:
Some studies claim to find adverse selection. My own paper cited
above is sometimes cited incorrectly as having found evidence of
adverse selection, when in fact the opposite is true. This
classification is consistent with common but incorrect usage. The
confusion in this case and in many others is the distinction between
true adverse selection as it is used in theory (selection based on
private information) and adverse selection as it is loosely used by
policymakers in practice.
For example, an excellent recent paper by Cohen (2003) claims to
find evidence of adverse selection in the Israeli auto insurance
market. Cohen finds a positive relationship between insurance coverage
choices and the frequency of subsequent accidents. A peculiar feature
of that market is that insurers do not use driving histories to set
premiums for new customers. The so-called private information in this
market is only private because insurers ignore available information
that is commonly used in other countries. Even so, the insurance market
still functions reasonably well.
The papers cited here should cast some doubt on the severity of the
problem. A failure to find evidence of informational advantages leading
to adverse selection in a given market does not mean, of course, that
it cannot or does not occur; rather, it means that the problems that do
exist are swamped by other factors or that the problem has been managed
by consumers and insurers in some other way.
To return to the original example of adverse selection, the used
car market is supposed to break down due to severe adverse selection,
and yet it is clear there is a robust market for such cars. Obviously
when buying a used car a consumer must consider the Lemons problem. But
buyers and sellers have arranged institutions to control the problem.
Warranties, inspections, seller reputation and the prospect of repeat
dealing are examples of how markets deal effectively with a potentially
serious problem. People are clever, and they adjust in order to make
things work. So the market that inspired concerns about adverse
selection is in fact a fairly good example of market success. Ebay is
another example of a market that should suffer from informational
problems, and yet it continues to grow. Buyer and seller reputation
play an important role here.
I maintain that `death spiral' concerns are exaggerated, and that
informational advantages are often either small or two-sided, with both
buyers and sellers having private information. Many cases of so-called
adverse selection are due to deliberate neglect of available
information. In health insurance markets, several factors mitigate the
problem of residual private information. Benefits managers adjust
premiums and benefits to maintain stable enrollment. There are also
non-price remedies available. For example, my own benefits plan
includes a low cost, higher cost-sharing option. Enrollment in this
plan is for a minimum of 2 years, and this provision prevents employees
from frequent switching from high to low coverage.
POTENTIAL FOR ADVERSE SELECTION IN CONSUMER-DIRECTED PLANS
Archer MSAs have been available to small businesses for several
years in a very restrictive way. Health Savings Accounts (HSAs) were
introduced as part of the Medicare Prescription Drug, Improvement and
Modernization Act of 2003. With HSAs, consumers and their employers are
able to contribute pre-tax dollars into these accounts to use for out-
of-pocket medical expenses. To qualify, consumers must be covered by a
health plan with a relatively high deductible of between $1,000 and
$5,000 for an individual and between $2,000 and $10,000 for a family.
Preventive care is excluded from this restriction and can receive
first-dollar coverage:
These plans offer consumers and employers greater flexibility in
plan options, and there is potential to improve the delivery of health
care and increase insurance enrollment by lowering costs. Part of the
reason for rising health costs is that insured patients will over-
consume health care because they often pay only a small portion of
health expenditures. HSAs seek to reduce this inefficiency by combining
higher cost-sharing with a tax-preferred saving account. Catastrophic
coverage is the most important component of any insurance plan because
it protects us from financial ruin. Coverage for small, predictable
expenditures is largely a result of a tax code that encourages us to
pay for such expenses through an insurer instead of out-of-pocket.
There is some confusion about what HSA balances represent.
Accumulated balances are wealth that reasonable people will use wisely.
As such, there would seem to be little concern that individuals with
large balances will overspend. In general, the perceived cost of using
$1 from the account will reflect the cost of replacing that $1 the
following year, which depends in part on the individual's tax rate. For
example, if the tax rate is 30 percent, then the cost of replacing the
dollar is $.70. In effect, these plans are low cost, less-comprehensive
plans with deductibles to limit risk. Unused balances can eventually be
withdrawn as retirement income. Because of this provision, even very
large balances will not be spent carelessly.
Concerns have been raised that these plans benefit the wealthy and
offer another tax shelter. This is true, but all rules that allow
income to be sheltered from taxes benefit the wealthy, since they face
higher marginal tax rates. An employee's share of employer provided
insurance is already paid using pre-tax dollars. Retirement savings
receive the same tax treatment, but putting money in an HSA is
preferable to putting it in an IRA because HSA offers the option of
using balances for health care.
One commonly-made argument against HSAs has been that they will
lead to a segmentation of health insurance markets that will exacerbate
the standard adverse selection problem, leading either to increased
risk segmentation in a separating outcome or to the premium `death
spiral' in which exit of the healthy from comprehensive plans raises
premiums to the point that the market for such insurance collapses.
At an intuitive, common sense level, I believe concerns that HSAs
will distort markets are greatly exaggerated. So far as risk
segmentation is concerned, HSAs are similar to existing high-deductible
or other plans with high levels of cost-sharing, and benefits managers
know how to manage enrollment among a variety of plans by adjusting
premiums and plan benefits.
There are two possibilities that we should consider. First, adding
an HSA option to menu of plan offerings is like adding a less-
comprehensive plan to the menu. This may be in addition to or in place
of an existing low-coverage option. Again, this is nothing new, and
should be manageable. I believe it is more likely that introducing the
HSA might drive out the alternative low-coverage plan, leaving a choice
between more comprehensive options and the new HSA.
Second, a firm that offers a single plan option might be replacing
a traditional fee for-service plan or an HMO with an HSA. That is, the
comprehensive plan in the pooling outcome is replaced with an HSA. This
case might cause greater concern because this would leave employees
with no alternative. However, employers can vary the generosity of the
HSA by changing' premiums and the employer contribution to the account.
A move to an HSA might reflect a trend toward offering lower levels
of coverage in the face of rising health care costs. Worker
compensation consists of a combination of cash wages and benefits, and
will be determined by worker productivity. Tax policy, regulations, and
employee preferences determine the precise mix between wages and
benefits. Cutting benefits makes firms less competitive in attracting
and retaining workers, so firms must have a good reason for cutting
benefits. The availability of new style of plan does not seem to be
such a reason unless the firm believed the new plan was more efficient.
Health economics is a very challenging field, and the models and
language involved tend to induce headaches. After all the analysis,
markets will provide the final test: If HSAs work, then they will
become popular. If they do not work, then they will disappear. After
all, traditional plans will continue to be available, and decisions are
usually biased against change. If firms find that HSAs are not a good
match for their employees, they will drop HSAs. HSAs will likely become
a useful alternative to less-comprehensive insurance or managed care,
and they are worth a try.
REFERENCES
Akerlof, G. A. (1970). ``The Market for `Lemons': Quality
Uncertainty and the Market Mechanism,'' Quarterly Journal of Economics
84, 488-500.
Cardon J. and I. Hendel (2001). ``Asymmetric Information in Health
Insurance: Evidence from the National Medical Expenditure Service,''
RAND Journal of Economics 32, No. 3, pp. 408-427.
Cawley J. and T. Philipson (1999). ``An Empirical Examination of
Information Barriers to Trade in Insurance,'' American Economic Review
89, pp. 827-846.
Cohen, A. (2003). ``Asymmetric Information and Learning: Evidence
from the Automobile Insurance Market,'' Harvard Law and Economics
Discussion Paper No. 371.
Crocker, K. and J. Moran (2003). ``Contracting with Limited
Commitment: Evidence From Employment-Based Insurance Contracts,'' RAND
Journal of Economics 34, No. 4, pp. 694-718.
Rothschild M. and J. Stiglitz (1976). ``Equilibrium in Competitive
Markets,'' Quarterly Journal of Economics, 90, 629-49.
__________
Prepared Statement of Jeffrey M. Closs, President and CEO, BENU, Inc.
1. INTRODUCTION
Good morning Mr. Chairman and members of the Committee. I am Jeff
Closs, President and Chief Executive Officer of BENU, Inc. I am pleased
to be here today to participate in the hearing on ``Expanding Consumer
Choice and Addressing `Adverse Selection' Concerns in Health
Insurance''. This topic is exactly what my company, BENU, addresses for
small and mid-size companies today. We have a relationship with CIGNA
Health Care and Kaiser Foundation Health Plan in Oregon, and CIGNA and
Group Health Cooperative in the State of Washington, to offer choice of
health plan delivery systems for employers to offer to their employees,
yet reallocate premium to insurers to correct for the adverse selection
that inevitably occurs.
Health insurers compete aggressively for the business of the
employer. What they cannot do is compete aggressively for the consumer.
Let me give you an example. The marketing executive for Group Health
Cooperative told us of the wonderful way they treat diabetics. He spent
considerable time describing their prescription system which flags a
new insulin prescription, which triggers a nurse to call the diabetic
person for education on the best methods of monitoring and controlling
their blood sugar, to make an appointment with a dietician to review
their nutrition and to schedule follow-up appointments to screen for
additional diseases. I marveled at the comprehensiveness and
effectiveness of their care. But when I asked ``Why not encourage all
diabetics to join Group Health'', he said ``Of course we would love to
care for all the diabetic people, however, our current payment of the
average' premium will not cover the cost of treating the diabetic
person no matter how efficient the care!
Our health insurance system is broken. The problem is that we
expect our health insurance carriers to be more than plain old
insurance. I define insurance as a financial vehicle that spreads the
risk of financial calamity from rare, unpredictable events--not
predictable events--among a large group of people. If I tried to apply
for home insurance while my house was on fire, and I was turned down,
would you be surprised? Of course not. But when a woman with leukemia
can't get health insurance, we find that unacceptable. We expect our
health insurers to be part social program. Do we expect insurers to be
paid the same rate for bad drivers as they receive for good drivers? Of
course not. But to engage an insurer to compete for the diabetic as
well as the healthy we need to compensate them appropriately. The truth
is we expect our health insurance carriers to be part service plan,
taking good care of the healthy and chronically ill alike, and part
social program, spreading the cost of health care evenly among all
participants. Unsurprisingly they are having a hard time being either.
Why is consumer choice so important? It is so we can create an
efficient, competitive consumer market whereby insurers have the
incentive to provide the service plan component. If insurers are paid
appropriately, they will have the incentive to enroll the chronically
ill as well as the healthy since they have the potential to make a
profit. If they fail to provide high quality care, consumers can `vote
with his or her feet' and change to another insurer that will care for
them appropriately. In this model, aligning insurer payment to enrolled
risk creates an incentive for insurers to provide efficient, high
quality health care.
What we need is an ability for consumers to make choices among
competing delivery systems, to make value judgments between cost and
quality when assessing their choices. If one system provides better
care at an appropriate price, they should have the ability to choose
that delivery system. If the diabetic feels Group Health offers
superior care for their needs, they should be able to enroll with Group
Health, without Group Health fearing they are going to create
unsustainable losses.
But what if I told you that there was a way to fix this system,
whereby we could keep the social program aspects of our system, give
consumers choices they need, while at the same time engage insurers to
compete for all consumers and control costs for employers? In fact,
BENU does this today by reallocating premium using risk assessment
tools available today.
What is wrong with the current system is not how we FUND health
care, but how we PAY insurers. We FUND health care by charging everyone
the same premium for the same plan, no matter how sick they are, what I
call the AVERAGE COST MODEL. That's how we retain the social program
part. But instead of paying the INSURER this average cost model
premium, we should adjust payments to insurers based on the chronic
illness of those who they enrolled, what I call the RISK-
ADJUSTED MODEL. In other words, employers can still offer employees a
premium-subsidy based on the AVERAGE COST MODEL, but insurers should be
paid using a RISK-ADJUSTED MODEL.
2. EVIDENCE: LACK OF INSURER COMPETITION
Very few employers offer a choice of health plan, let alone choice
of insurers. In 2004, 84 percent of all United States employers offered
only one health plan to their employees\1\. The percentage of employers
that offer more than one plan increased with employer size; however, in
most cases, the additional options were simply different plans offered
by the same insurer. For example, an employer might offer an insurer's
point-of-service (POS) plan as well as their preferred provider
organization (PPO) plan. Typically such plans are served by the same
provider networks, so consumers are not offered competition among
different delivery systems but rather different financing mechanisms
for the same delivery system. Very little data exists regarding how
many employers offer more than one insurer, but it is certainly less
than 16 percent, which is the percentage of employers that offer more
than one plan.
---------------------------------------------------------------------------
\1\ The Kaiser Family Foundation--Health Research and Educational
Trust, Employer Health Benefits Annual Survey (Chicago and San
Francisco 2004): 59.
[GRAPHIC] [TIFF OMITTED] T7228.001
3. CAUSE: AVERAGE COST MODEL
Insurers charge a premium that closely matches the average member's
expected cost to the insurer for the upcoming year. But individual
members' expected costs vary dramatically. Someone with chronic heart
failure is expected to cost much more than a healthy twenty-year-old.
From a financial standpoint, the insurer prefers to enroll the healthy
and not the chronically ill. Of course, this runs counter to the
commonly assumed mission of insurers to cover the cost of those who
need medical care. Every chronically ill member enrolled costs the plan
more than his or her premium. Therefore, there is a disincentive to
recruit the chronically ill, and it is this average cost model that
creates the misaligned incentive\2\.
---------------------------------------------------------------------------
\2\ R.E. Herzlinger, Consumer-Driven Health Care: Implications for
Providers, Payers, and Policymakers (San Francisco: Jossey-Bass
Publishers, 2004); 77-83.
---------------------------------------------------------------------------
4. ETIOLOGY: HOW DID WE GET HERE?
How did the health insurance industry arrive at an average cost
model? Because health insurance is more than just plain old insurance.
It is also a service plan and a social program, which make the current
average cost payment model inefficient and costly.
First, health insurance is insurance: a financial vehicle that
spreads the risk of financial calamity from rare, unpredictable events
among a large pool of members. Health insurance originated in the
1930's primarily as a means of protecting individuals from unexpected
hospital costs.\3\ These costs were due primarily to acute conditions,
and thus unpredictable. A casualty insurance model for health care
financing was therefore appropriate at the time.
---------------------------------------------------------------------------
\3\ P. Starr, The Social Transformation of American Medicine (New
York: Basic Books, Inc. Publishers, 1982): 295-306.
---------------------------------------------------------------------------
While the casualty model made sense in the 1930's, advances in
medicine have created a new group of individuals with chronic illnesses
who live much longer, requiring expensive ongoing care. For the
insurer, this has meant that loss expectations include not only claims
due to unpredictable events, but also some due to predictable events as
well. A patient with kidney disease, who did not have a life expectancy
of more than a few months in the 30's, now may live many years thanks
to costly dialysis treatments. This service plan component of modern
health insurance, in which one pre-pays for anticipated services in the
coming year, does not exist in other lines of insurance. A purchaser of
life insurance does not expect to die next year when he buy's term life
insurance, nor does a homeowner expect that her house will burn down
when she buys homeowner's insurance. (If they did, it would be fraud!)
But with health insurance, the insured expects to consume services and
file claims in the contract year. A component of costs has become
predictable.
Modern health insurance is also unique because of the expectation
that the known healthy will subsidize the cost of care for the sick. A
recent newspaper article described the case of an uninsured woman who
was diagnosed with leukemia. The article lamented that she could not
buy insurance to cover the costs of chemotherapy treatments. This
sounds reasonable to us. But, by the same token, it would not seem
reasonable to us for a person whose house is on fire to buy fire
insurance. Why do we think differently about health insurance? Because
as a society we view health insurance as part social program.
The social program aspect of health insurance has created the
average cost model for insurer payment. It is the social program aspect
of health insurance that prevents us from charging the person with
cystic fibrosis his or her full expected cost in the upcoming year.
Instead, the cost is spread amongst the rest of us who are fortunate
enough not to have been born with the illness.
5. RESULT: SINGLE INSURER, FULL-REPLACEMENT HEALTH PLANS
The average cost model has perpetuated employers' use of a single
insurer, full-replacement approach in the health insurance they offer
to employees. Insurers market aggressively to employers, competing for
a company's entire membership. But if an employer wishes to offer an
additional insurer's health plan to their employees (called `slice
business') the original insurer resists, not just because the original
insurer wants to retain the business, but because they fear enrolling
the costlier portion of the group, a phenomenon called adverse
selection:
Adverse selection makes it difficult, if not impossible, for
insurers to compete effectively at the consumer level. Historically,
insurers have pursued slice business as a means of writing more
business. But this extra business is unprofitable if the new members
are sicker than the group by which the average cost premium was set. As
a result, most insurers will not share enrollment of the same employer
group with a competing insurer.
Another way of looking at it is that adverse selection occurs when
consumers are offered a choice of insurers and health plans and are
exposed to significant cost differences between those plans. A consumer
who does not expect to need much health care in the coming year will
not see value in choosing the costlier plan. The chronically ill
member, who does need a lot of care in the coming year, will likely
consider that costlier plan.
When insurers allow slice business, they implement strategies to
create an equal sprinkling of the healthy and the chronically ill among
all of the insurers offered. They do this to create an enrollment with
each insurer with an average cost potential equal to the average cost
of the group. One way to achieve this is to standardize benefit designs
across insurers to lessen the cost variance between insurers. Another
way is to require the employer to subsidize a major portion of the cost
difference between insurers.
Unfortunately for employers and employees, the mechanisms insurers
use to mitigate adverse selection eliminate the reasons why employers
want to offer choice in the first place: a meaningful choice of
insurers and plans with meaningful price differences that allow
consumers to make value assessments between cost and quality. Add to
this the administrative complexity for employers of offering more than
one insurer to employees, and one can see why the average cost model
leads to a single insurer, full-replacement model of health insurance
coverage.
6. IMPLICATION: INCREASED HEALTH CARE COSTS
In a single insurer, full-replacement model, the employer is the
one choosing the insurer, not the employee. But employers are not as
effective as employees in making value assessments because individual
needs and preferences differ. In the late 1980's and early 1990's many
employers controlled double-digit health care inflation by forcibly
moving their employees into managed care. With restricted networks and
tight utilization controls, managed care slowed health care inflation
dramatically. While many employees did not mind this style of care,
others disliked the restriction of services that used to be abundantly
available. The managed care backlash led employers to negotiate with
their insurers to lessen the utilization controls and to be more
inclusive in their networks. Employee satisfaction increased, but costs
again skyrocketed.\4\
---------------------------------------------------------------------------
\4\ A.C. Enthoven and S.J. Singer, ``The Managed Care Backlash and
the Task Force in California,'' Health Affairs 17, no. 4 (1998): 95-
110.
---------------------------------------------------------------------------
The single insurer, full-replacement model of health insurance
coverage does not control costs. It leads instead to a demand for all-
inclusive networks, forcing the insurer to include the efficient and
the inefficient, and the good and the poor quality provider. These wide
networks are not the cohesive provider organizations needed to
efficiently take care of the chronically ill.\5\
---------------------------------------------------------------------------
\5\ A.C. Enthoven, ``Employment-Based Health Insurance Is Failing:
Now What?'' Health Affairs (Web Exclusive May 2003): 237-249.
---------------------------------------------------------------------------
7. SOLUTION: CONSUMER CHOICE OF COMPETING INSURERS AND PAYING INSURERS
FOR RISK ENROLLED
The best way for employees to become engaged in value assessments
is to have employers offer them a meaningful choice of health plans
from competing insurers. Competition among insurers creates incentives
to provide value to consumers and maximizes consumer satisfaction. If
consumers are exposed to the true cost differences between insurers,
they will have a reason to choose less expensive delivery systems or
costlier options if they see value in doing so. This is called a
defined-contribution approach because employers offer all employees a
fixed-dollar subsidy to their health plan choice. This approach is
necessary for consumers to make value assessments. It yields savings
for the employer by allowing them to fund only the lowest cost plan,
employees then buy-up to the options they desire.
[GRAPHIC] [TIFF OMITTED] T7228.002
Figure 2 demonstrates how an employer who currently offers only one
moderately priced, one-size-fits-all PPO can save significantly by
introducing a lower cost, comprehensive HMO plan from a competing
insurer. In the single insurer situation, the PPO plan premiums are
$250 and the employer pays 90 percent of that, or $225. In the package
with choice, the HMO costs $200 per month and the PPO is still $250. If
the employer subsidizes $200, then it yields a $25 savings per covered
employee. The employees now have a no-cost option, but they can keep
the PPO if they are willing to spend $50 per month, the cost
differential between the plans.
Insurers, however, need to be kept whole in this process. While
average cost payments from employers can be maintained (social
program), an intermediary, such as BENU, must reallocate payments to
insurers proportional to chronic illness burden, or `risk', that
enrolls (service plan). In the example in Figure 2, healthier employees
will be attracted to the low cost HMO option, raising the average per-
employee-cost of those remaining in the PPO. Risk assessment tools that
predict future costs based on clinical diagnoses can reallocate the
average cost rates funded by employers into risk-based rates paid to
insurers.
Paying insurers risk-adjusted rates allows employers to offer a
choice of insurers while pursuing a defined contribution strategy that
was not sustainable when the employer paid the insurer the average
cost. Employers protect themselves, but employees are empowered to make
the value assessments critical for efficient competitive markets.
8. ADDITIONAL BENEFIT: MORE ATTENTION TO THE CHRONICALLY ILL
When employers offer choice to employees without risk adjusting
payments to insurers, powerful incentives are created for insurers to
figure out how to enroll low cost, healthy members and not to enroll
high cost, chronically ill members. One cannot blame insurers for this
strategy. When employer's offer a choice of insurers in an average cost
model, it creates financial calamity for insurers that actively recruit
the chronically ill. Consider an HMO that may have an excellent
diabetes care pathway, including an early detection system that
identifies new enrollees with insulin prescriptions, an education
program taught by nurses, a nutrition program in which a dietician
contacts patients with nutritional advice, and a followup care program
with specialists who help with co-morbid disease prevention. The HMO
then markets this excellent program to an employer that will offer it
to employees. But when it comes time to enroll members, there is no
incentive for the insurer to enroll the diabetics. Why? Because the
average premium is not sufficient to cover the costs of the diabetic,
no matter how good the care is.
If employers pay insurers premiums commensurate with the chronic
illness burden of enrollees, it will actively encourage these plans to
compete for all members, effectively removing the underwriting profit
incentive. Insurers will have the incentive to provide high quality
care to the chronically ill because they represent greater revenue. If
they fail to do so, the chronically ill member can vote with his or her
feet and change to another insurer that will care for them
appropriately. In this model, aligning insurer payment with enrolled
risk creates efficient, high quality, cost effective health care.
9. SOLUTION FOR EMPLOYERS: BENU'S RISK-ADIUSTED PREMIUM PAYMENTS
BENU is currently the only independent 3rd party market-maker that
allows employers to maintain average cost premiums for their employees,
yet pays risk-based premiums to insurers. The key to BENU's method is
to present rates to employers that the insurer would quote if each plan
were to receive the entire enrollment, what BENU calls the group
neutral risk level. After enrollment, BENU calculates the insurer-
enrolled risk level and adjusts the premium paid to each insurer
proportionately. Essentially, the rates that BENU pays the insurers are
what the insurers would have quoted had they known in advance the
enrollment they eventually received.
The rates BENU charges and collects from the employer for insurers
differ from the rates that BENU pays the insurer, but the total premium
the employer pays BENU equals the total premium paid to insurers.
Figure 3 shows how the average enrolled risk for insurers can
differ from the group neutral risk.
[GRAPHIC] [TIFF OMITTED] T7228.003
10. RESULTS: EXPERIENCE AT BENU
BENU currently operates in two states, Oregon and Washington. In
Washington we currently offer Group Health Cooperative and CIGNA Health
Care, while in Oregon we offer Kaiser Foundation Health Plan of the
Northwest and CIGNA Health Care.
How does BENU assess risk? BENU uses predictive modeling tools
developed over the last decade. Specifically, BENU uses DxCG software,
the same company that the Medicare program currently uses in
determining payment to insurers in the Medicare+Choice program. The
software was developed by using claims data from a large data set of
over two million members over a period of 2 years. By tracking
diagnoses that are recorded for members in the first year with costs
those members generate in the second year, a statistical model was
created where future year costs can be predicted based on prior year
diagnoses. To use the software, one simply enters the diagnoses for
each member and the software will generate relative cost factors for
each member. We call this a prospective risk factor.
For example, a member diagnosed with diabetes in the first year may
have a prospective risk factor of 3.2. This means that next year, we
can expect, on average, that this member will incur 3.2 times the cost
of the average cost per member of the two million members in the
original reference data set.
[GRAPHIC] [TIFF OMITTED] T7228.004
Figure 4 demonstrates the amount by which prospective risk factors
can vary for a typical BENU employer. The graph shows prospective risk
factors for each member in a 275 member group, ordered from highest to
lowest. The prospective risk factor at the extreme left is 15.33,
representing a member diagnosed with cancer. The factor at the extreme
right is about 0.08, representing a completely healthy individual that
never needed to see a physician. The most costly member in this group
is expected to cost 192 times the cost of the least costly member in
this group. This example demonstrates a 192-fold difference between
what the costliest and least costly member is expected to cost. Yet the
insurer is paid the average premium whether the member with the
prospective risk factor of 15.33 or the one with 0.08 enrolls.
How much has BENU reallocated premium among insurers? Figure 5
answers this, showing the results for the first 13 employers to
purchase health insurance through BENU.
[GRAPHIC] [TIFF OMITTED] T7228.005
Notice how in several groups the adjustment altered premium more
than 5 percent, which is significant because insurers operate on less
than 5 percent profit margin. Adverse selection can easily turn slice
business into an unprofitable venture. Without risk adjustment, the
insurer that received the higher proportion of chronically ill would be
forced to raise premium, making the cost share to the employee higher,
further exacerbating the adverse selection, eventually making the
affected insurer leave the offering--a situation called the death-
spiral. Risk adjusted premiums to insurers prevent the death-spiral.
11. RISK ADJUSTMENT IN OTHER GOVERNMENT PROGRAMS
As mentioned above, BENU uses the same predictive modeling software
as currently used by the Medicare program in determining payments to
insurers in the Medicare+Choice program. Several Medicaid programs
across the country are using similar predictive modeling tools in their
programs as well. If participants in these programs have a choice of
insurers, it bodes well for creating efficient health care since
insurers will actively compete for all participants, the chronically
ill as well as the healthy, and yet create economic pressures (i.e.,
loss of patients) on the most costly alternatives to innovate to
contain and reduce cost. The most efficient plans gain market share and
are rewarded for being economical.
12. CONCLUSION
Our current system of paying insurers perpetuates a single-insurer
full-replacement model of health insurance coverage that leads to
higher costs. While the current system may be an appropriate way to
fund health care, it is not an appropriate way to pay insurers. BENU's
risk adjustment method sensibly reallocates the funding of health care
to pay insurers in a manner that creates a competitive consumer market
that lowers costs for employers, satisfies employees and motivates
insurers to provide value for the chronically ill.
__________
Prepared Statement of Linda J. Blumberg, Ph.D., Senior Research
Associate, The Urban Institute
Mr. Chairman, Mr. Stark, and distinguished Members of the
Committee: Thank you for inviting me to share my views on adverse
selection in health insurance and its implications when expanding
consumer choice in the private market. The views I express are mine
alone and should not be attributed to the Urban Institute or any of its
sponsors.
I applaud the Committee for taking the time to carefully consider
these issues, which are of paramount importance to individuals' access
to health care coverage and medical services. In brief, my main points
are:
In order to understand health insurance markets, there is
one overarching fact that must be understood. The distribution of
health expenditures is highly skewed, meaning that a small fraction of
individuals account for a large share of total health expenditures.
Because of this fact, the gains to insurers of excluding high cost
people swamp any possible savings from efficiently managing the care of
enrollees. The incentives for insurers to avoid high cost/high risk
enrollees are therefore tremendous.
Greater risk segmentation of the market means setting
individuals' health insurance premiums to more closely reflect each
individuals' expected health care costs. Conversely, greater risk
pooling implies increasing the extent to which individuals with
different expected health care spending levels are brought together
when determining premiums. Providing new health insurance options is
one way, intentionally or not, that the extent of risk segmentation can
be increased.
Reforms that increase risk segmentation are appealing to
some because they promise, and sometimes deliver, lower premiums for
currently healthy persons and because the majority of people are
healthy. However, gains from segmenting healthy groups can occur only
if premium costs for the unhealthy are increased, or if the unhealthy
are excluded from the market to a greater extent than is true today.
Examples of proposed and already implemented reforms that
will increase risk segmentation in private markets are: health savings
accounts (HSAs); tax deductions for the premiums of high deductible
policies associated with HSAs in the private non-group market;
association health plans (AHPs); and tax credits for the purchase of
non-group insurance policies.
While risk segmentation increases the costs of coverage
for the unhealthy, the isolated instances where states have forced
greater risk pooling have not been successful either. Efforts at
pooling have been limited to a small population base and have been
foiled by individuals and groups that opt out of our voluntary private
insurance markets.
Addressing the problem will require subsidization of the
costs associated with high cost individuals, with the financing source
being independent of enrollment in health insurance--ideally, all
taxpayers. In this way, the unhealthy could be protected from bearing
the tremendous costs of their own care while there would be little to
no disincentive for the healthy to give up coverage.
Three examples of policies that would move us closer to
such a paradigm are:
Dramatically increasing funding for State high risk
pools and making the coverage both more comprehensive and
easier to access;
Having the Federal Government take on a roll as
public reinsurer, particularly for the private non-group market
and for modest sized employers;
A more comprehensive strategy would allow groups to
continue to purchase insurance in existing markets under
existing insurance rules, while each State provides structured
insurance purchasing pools. Through these new pools, employers
and individuals could enroll in private health insurance plans
at premiums that reflect the average cost of all insured
persons in the state.
For the following reasons, introducing greater choice
within existing insurance pools will not solve the problems I
described. In fact, doing so will likely exacerbate them, even given
the best available risk adjustment mechanisms:
First, it is not sufficient to spread risks only
within a particular insurance pool.
Second, benefit package design is an effective tool
for segmenting insurance pools by health care risk--offering
less than comprehensive insurance will tend to attract
healthier enrollees.
Third, in private markets, where differences in
actuarial value of plans can be quite larger and where people
have the opportunity to opt in or out of the market, risk
adjustment becomes substantially more difficult. Risk
adjustment has been used in the Medicare program and is
universally considered to be inadequate.
And finally, it is not even clear that employers will
have a strong incentive to want to risk adjust across plans.
Although most employers want to lookout for the well-being of
all their workers, they face incentives to keep health care
premiums down while keeping their highest paid workers
satisfied. HSAs may provide employers with an effective tool
for responding to these incentives, but place a greater share
of the health care financing burden directly on the sick while
higher paid employees can be compensated via the tax subsidy.
Further segmentation of risk will not improve social welfare in the
U.S. Addressing the health care needs of all Americans and protecting
access to needed services for our most vulnerable populations--those
with serious health problems and those with modest incomes--will
require broad-based subsidization of both those with high medical costs
and income-related protection for those unable to afford even an
average priced insurance policy.
I. THE SCOPE OF RISK-RELATED HEALTH INSURANCE PROBLEMS IN
THE CURRENT MARKET
While estimates differ, by all accounts the number of uninsured
persons in the U.S. is large and prone to grow, both in absolute terms
as the population increases and as a percentage of the population. The
most recent estimate based upon the 2004 March Current Population
Survey is 45 million uninsured persons below age 65, or almost 18
percent of the non-elderly population. There is a substantial body of
evidence that shows that the uninsured have reduced access to medical
care. Many researchers have also determined that those without coverage
have worse outcomes in the event of` an injury or illness.
The distribution of health expenditures is highly skewed. Only a
small fraction of individuals account for most of our nation's health
care spending. In fact, the top 10 percent of the population, ranked by
expenditures, accounts for about 70 percent of total expenditures in
the country.\1\ The lowest 50 percent of spenders account for only 3
percent of expenditures. Because of this, insurers have strong
incentives to avoid enrolling high cost individuals and to aggressively
pursue enrollment of low cost individuals. The potential gains to
insurers of excluding the high cost cases swamp any possible savings
from efficiently managing the care of enrollees. The small group and
individual insurance markets are of greatest concern with regard to
adverse selection, since their variability of expenditures year-to-year
is much higher than for large groups.
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\1\ ML Berk and AC Monheit. 2001. ``The Concentration of Health
Care Expenditures, Revisited.'' Health Affairs. March/April; 20(2): 9-
18.
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Fears of adverse selection and the natural drive to maximize
profits, drives insurers in unregulated markets to use strategic
behavior in the pursuit of a disproportionate share of low cost
enrollees. These strategic behaviors can take a variety of forms,
including: excluding preexisting medical conditions from coverage for
defined periods; attaching riders that exclude specific conditions,
procedures, or body parts from coverage for the life of the policy;
engaging in medical underwriting (the process whereby insurers assess
an applicant's relative health risk and then charge higher premiums to
those whose risk is deemed to be higher than normal); or refusing to
sell an applicant insurance altogether.\2\ Another technique is
designing insurance benefit packages in such a way as to be more
attractive to healthy persons than to unhealthy ones. Harvard health
economist Joseph Newhouse demonstrated how insurers, in order to
protect themselves from adverse selection, can offer less than complete
insurance.\3\ This approach can take the form of offering coverage with
higher deductibles, higher limits on out-of-pocket liability, tighter
provider networks, and caps on benefits, among other things. In
essence, insurers use lower value benefit packages to help them
selectively appeal to the low risk.
---------------------------------------------------------------------------
\2\ MA Hall. 2000. ``An Evaluation of New York's Reform Law.''
Journal of Health Politics, Policy and Law. 25(1): 71-99; K Pollitz, R
Sorian and K Thomas. 2001. ``How Accessible is Individual Health
Insurance for Consumers in Less-Than-Perfect Health?'' Menlo Park, CA:
Henry J. Kaiser Family Foundation; U.S. General Accounting Office
(GAO). 1996. Private Health Insurance: Millions Relying on Individual
Market Face Cost and Coverage Trade-Offs. HEHS-97-8. Washington, DC:
U.S. General Accounting Office.
\3\ JP Newhouse. 1996. ``Reimbursing Health Plans and Health
Providers: Efficiency in Production Versus Selection.'' Journal of
Economic Literature. 34: 1236-1263.
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The result of these various strategies is to create a market that
is segmented by health care risk. This leads to markets in which
premiums faced by generally healthy persons are determined as a
function of the expected costs of a similarly healthy population, and
the premiums for the unhealthy are determined as a function of the
expected costs of the similarly unhealthy. The markets with the
greatest risk segmentation are those for small employers and for
individual purchasers, the markets where the insured groups are
smallest and the year-to-year variation in expenditures is the
greatest. While market segmentation benefits the currently healthy by
providing them lower premiums than they would face otherwise, it
increases the premiums faced by the relatively unhealthy, and sometimes
excludes them from the insurance market entirely.
Risk segmentation has made insurance more affordable for the
healthy and less affordable and accessible to the sick, contrary to the
classic theory posited by Rothschild and Stiglitz\4\ This result is
consistent with the framework posed by Newhouse.\5\
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\4\ M Rothschild and JE Stiglitz. 1976. ``Equilibrium in
Competitive Insurance Markets: An Essay on the Economics of Imperfect
Information.'' Quarterly Journal of Economics. 90(4):629-50.
\5\ JP Newhouse. 1996. ``Reimbursing Health Plans and Health
Providers: Efficiency in Production versus Selection.'' Journal of
Economic Literature. 34(3):1236-63.
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The best example of how risk selection can lead to barriers to
coverage for the unhealthy can be found in the private non-group,
insurance market. With a limited number of exceptions, State laws
permit non-group insurers to exclude individuals from coverage entirely
based upon health status and to set premiums as a function of health
status. They may also discontinue particular insurance products as a
consequence of the insurance pool becoming too expensive, and only make
alternative products available to the healthier individuals that had
been in that pool. In many states insurers are also allowed to severely
limit any coverage related to a pre-existing condition. For example, a
study of the accessibility of non-group insurance for people in less
than perfect health found examples of insurers offering one applicant a
policy which excluded any care related to his circulatory system, and
another excluding his entire respiratory system.\6\
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\6\ K Pollitz, R Sorian and K Thomas. 2001. ``How Accessible is
Individual Health Insurance for Consumers in Less-Than-Perfect
Health?'' Menlo Park, CA: Henry J. Kaiser Family Foundation.
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A recent empirical study published in the journal Inquiry found
that the probability of buying non-group insurance goes down
significantly as a person's health deteriorates.\7\ Using this
information to adjust for selection bias, an important econometric
correction that has been neglected in all other studies of premiums in
the non-group market, the authors also found that people with
significant health problems would face non-group premiums roughly 50
percent higher than their healthier counterparts. Without the
adjustment for selection bias, the data suggest that premiums do not
vary with health status and support the misleading inference that poor
health does not make the cost of non-group insurance unaffordable.
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\7\ J Hadley and JD Reschovsky. 2003. ``Health and the Cost of
Nongroup Insurance.'' Inquiry. Fall; 40:235-253.
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Risk selection incentives and dynamics can also be found in
situations where individuals are offered a choice of health insurance
benefit packages with significantly different actuarial values. While
with most other products, choice is considered beneficial to all
consumers, the case of health insurance benefit packages is
considerably more complicated. Initially, multiple options allow
individuals to choose the package that is most consistent with their
preferences. However, the tendency for individuals' preferences to be
highly correlated with their health care risk means that choice in this
market will tend to separate individuals into different packages by
their health status. Due to the pricing differences that result,
certain options may eventually be priced out of existence, because they
become too expensive for people to afford. The end result may very well
be a market that has no more choice than it had originally, but with
the options tailored to those preferring less comprehensive coverage.
An example of this in the group insurance market can be found in
the recent history of the Federal Employees Health Benefits Plan
(FEHBP). For years, Federal employees had a choice of a ``high option''
Blue Cross coverage and a ``standard option'' with a slightly higher
deductible and a few other limitations. For the typical employee, high
option was worth a little more, and, initially, premiums were slightly
higher. Young, healthy employees risked having to pay the higher
deductible in exchange for the small premium savings. Older, sicker
employees preferred the high option. But the premium difference grew
larger over time as more healthy people shunned the high option. When
last offered in 2001, the high option family premium was $1500 more
than the standard option. In 2002, the high option was dropped from the
plan.\8\
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\8\ L Burman and LJ Blumberg. 2003 ``HSAs Won't Cure Medicare's
Ills.'' The Urban Institute. November; http://www.urban.org/
url.cfm?ID=1000578.
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Over the last 10 to 15 years, well-intentioned reformers, hoping to
provide protections in private insurance markets for high risk
individuals and groups, have enacted legislative mechanisms for forcing
more risk pooling than private insurance markets would have done on
their own. In their most extreme forms, such as pure community rating,
and particularly within the private non-group insurance market, such
approaches appear to have increased premiums and have led to a
reduction in the number of healthy individuals choosing to purchase
health insurance. In some cases, the effect has been sufficiently great
that the insurance in the community rated market may not be sustainable
in the long run.\9\
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\9\ See, for example, AC Monheit, JC Cantor, M Koller and KS Fox.
2004. ``Community Rating And Sustainable Individual Health Insurance
Markets In New Jersey.'' Health Affairs. July/August; 23(4): 167-175.
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II. RATIONALE FOR CHANGING OUR HISTORICAL APPROACH TO POOLING
HEALTH CARE RISK
Equity judgments inevitably arise in any discussion of the optimal
level of risk pooling. Many would consider lack of available coverage
for high risk people as inequitable, while others consider it
inequitable to force healthy persons to pay higher premiums than they
would under stronger market segmentation conditions. I argue that
neither our historical experience with the largely unregulated market
outcome of risk segmentation nor with forced pooling within small group
and non-group markets truly serve to maximize social welfare for the
following reasons:
First, we know that individuals with their own medical problems or
who have family members with medical problems often have difficulty
accessing needed care if they do not have employer-based or public
insurance available to them. But, additionally, all individuals age and
medical expenses tend to increase over time as a consequence, and
currently healthy people might face high costs someday because of
illness or injury. With segmented markets, their premiums would then
rise, perhaps beyond their ability to pay. Broad-based pooling
preserves access to reasonably priced health insurance over time. This
gives even currently healthy people reason other than pure altruism to
be concerned with effective access to care for the sick, and makes the
pursuit of risk segmentation much less than ideal.
Second, competition to avoid high-cost groups, and benefit designs
structured to place heavier financial burdens on the sick can foreclose
options that most consumers are willing to pay for if priced on a
broad-based average.\10\ This is an efficiency loss to the society. If
the risk pool were guaranteed to be sufficiently broad-based, consumers
might be eager to buy coverage that was more comprehensive, for
example, shorter pre-existing condition exclusion periods or lowering
out-of-pocket maximums. Additionally, pharmaceutical benefits and
rehabilitation benefits in the non-group market are often either
severely limited or excluded altogether. Because there are many more
healthy than sick. people, these types of options could be available
for a small premium increase--if (and this is a big if) the size of the
pool over which these risks were to be spread was sufficiently large.
---------------------------------------------------------------------------
\10\ LJ Blumberg and LM Nichols. 1996. ``First, Do No Harm:
Developing Health Insurance Market Reform Packages.'' Health Affairs.
Fall; 15(3): 35-53.
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Third, sporadic efforts across various states to force pooling in
the smallest of private health insurance markets--those for small
groups and individual purchasers--have often not been constructive
largely because the financial burden for covering the high cost in
these markets can be avoided completely by the healthy by simply opting
out of the market and not buying coverage there. The price to consumers
of health insurance in these markets is a function of the health care
risk of those who voluntarily decide to enter them. Because the sick,
having greater health care needs, are more likely to enroll in
insurance, and because these markets are quite small in total, placing
the burden of the excess costs associated with bad health entirely on
those voluntarily enrolling in these markets is a primary cause of
their ineffectiveness at providing worthwhile coverage to individuals
of all health care statuses.
I suggest that none of our policy efforts to date have focused
properly on the source of the risk issues in our small group and
individual markets. Therefore, sticking with what we have, or
exacerbating risk segmentation relative to what we see in markets today
will not solve our problems either. It is not that broad based
spreading of health care risk is inappropriate, as demonstrated by the
fact that all individuals have some stake in maintaining access to
coverage for the unhealthy and that market efficiencies result from the
battle of insurers to avoid adverse selection. The problem is that our
efforts at pooling thus far have been limited to too small of a
population base and have been foiled by the ability of individuals and
groups to opt out of sharing risk by exiting particular insurance
markets, a dynamic that we know is related to expected health care
risk.
Addressing the problem, therefore, will require subsidization of
the costs associated with high cost/high risk individuals, with the
financing source for doing so being independent of enrollment in health
insurance. Ideally, the source of funding would be all taxpayers. In
this way, the unhealthy could be protected from bearing the tremendous
costs of their own care precisely at the time that they are both
medically and financially at greatest risk, while there would be little
to no disincentive for the healthy to avoid or drop health insurance
coverage due to the presence of high cost cases.
III. POLICIES WHICH WOULD ADDRESS OUR NEED FOR EFFECTIVE INSURANCE FOR
ALL HEALTH CARE RISKS
There are a number of policy options that would either begin to
lead us toward such a paradigm or move us most of the way there,
depending upon our current level of ambition and willingness to pay.
First, we can dramatically increase funding for State high risk
pools and make the coverage both more comprehensive and easier to
access. These pools are available to individuals who have been refused
insurance coverage in the private market, and who do not have offers of
employer-sponsored insurance. While many states currently have high
risk pools, due to the limited public funding through State sources
(frequently premium taxes on private insurance policies), these pools
may have enrollment caps and usually charge premiums that are well in
excess of standard policies in the private market.\11\ Some high risk
pools offer very limited benefit packages and maintain pre-existing
condition exclusion periods. This means that, in order to enroll, some
individuals with high cost medical conditions must be able to afford to
pay the high risk pool premium and, simultaneously, all of their
medical costs out-of-pocket for a year. All of these limitations hamper
the pools' effectiveness in absorbing risk from the private market.
However, broadening the base for financing these pools, loosening
eligibility criteria for enrollment, making the insurance policies
themselves more comprehensive, and offering income-related premiums
have the potential to make these high risk pools powerful escape valves
for the high cost in private insurance markets.\12\ Allowing employers
in the small group market in particular to buy their high risk workers
into well-funded high risk pools would decrease the level and
variability in the expenditures of the remaining small group workers
and, consequently, would lower their premiums. The cost of subsidizing
the medical care of the high risk could be spread across the entire
population, using a broad-based tax.
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\11\ ``D Chollet. 2002. ``Perspective: Expanding Individual Health
Insurance Coverage: Are High Risk Pools the Answer?'' Health Affairs,
Web Exclusive, October; W349-W352.
\12\ LJ Blumberg and LM Nichols. 1996. ``First, Do No Harm:
Developing Health Insurance Market Reform Packages.'' Health Affairs.
Fall; 15(3): 35-53.
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A second strategy is to have the Federal Government take on a roll
as public reinsurer, particularly for the private non-group market and
for modest-sized employers. In this capacity, the government could
agree to absorb a percentage of the costs of high cost cases, once a
threshold level of health expenditures had been reached.\13\
Reinsurance of this type would not only lower private premiums
directly, due to the broader financing of these expensive cases, but
would reduce the variance in expenditures considerably and therefore
should reduce risk premiums charged by private insurers.\14\ Focusing
on small employers and the non-group market could target government
spending where costs are highest and insurance markets most unstable.
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\13\ K Swartz. 2003. ``Reinsuring Risk to Increase Access to Health
Insurance.'' AEA Papers and Proceeding. May; 93(2).
\14\ LJ Blumberg and J Holahan. 2004. ``Government Reinsurer:
Potential Impacts on Public and Private, Spending.'' Inquiry. 41(2):
130-143.
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While private reinsurance does exist in some markets, such products
do not address the critical issues which are the focus of a public
reinsurance approach.\15\ Voluntary private reinsurance policies are
subject to the same selection concerns as are the insurers that they
are designed to cover. Those insurers who have historically attracted
high cost individuals and high cost groups find the private reinsurance
products either very expensive or inaccessible to them. In addition,
the costs of the reinsurance products must be passed back to the
individuals and groups purchasing the original insurance, again
creating incentives for low risk individuals and groups to avoid the
burden of risk sharing by opting out of the insurance completely.
---------------------------------------------------------------------------
\15\ LJ Blumberg and J Holahan. 2004. ``Government Reinsurer:
Potential Impacts on Public and Private Spending.'' Inquiry. 41(2):
130-143.
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A third option is to develop purchasing pools which would combine
the concepts of administrative economies of scale with direct
subsidization of the high cost.\16\ This proposal allows groups wishing
to purchase insurance in existing markets under existing insurance
rules to continue to do so. However, it would provide structured
insurance purchasing pools in each state, through which employers and
individuals could enroll in private health insurance plans at premiums
that reflect the average cost of all insured persons in the state.
Broad-based government funding sources would compensate insurers for
the difference between the cost of actual enrollees and the statewide
average cost.
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\16\ J Holahan, L Nichols, and LJ Blumberg. 2001. ``Expanding
Health Insurance Coverage: A New Federal/State Approach.'' In Covering
America: Real Remedies for the Uninsured, J Meyer and E Wicks, eds.,
Economic and Social Research Institute.
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Comprehensively addressing the problems of the uninsured would
require additional subsidization of the low-income population, aside
from techniques, such as those described above, which are aimed at
addressing the problems of risk selection.
IV. POLICIES THAT ARE LIKELY TO INCREASE RISK SEGMENTATION IN PRIVATE
MARKETS
A number of policies, some already written into law, would tend to
increase the segmentation of health care risk in today's insurance
markets and/or would increase the share of medical expenses left
uncovered by health insurance, without providing protections for the
high risk or the low income. The implications of implementing such
changes could be very harmful to these already vulnerable populations.
Some could come with sizable Federal price tags, without necessarily
increasing health care coverage on net.
Health Savings Accounts (HSAs), passed into law along with Medicare
legislation last year, are one such example. The legislation provides a
generous tax incentive for certain individuals to seek out high
deductible health insurance policies. Individuals and families buying
these policies, either through their employers or independently, can
make tax-deductible contributions into an HSA account. Annual
contributions are capped at the amount of the annual deductible for the
plan in which they enroll. Money in the account and any earnings are
tax-free if used to cover medical costs.
These accounts are most attractive to high income people, and those
with low expected health expenses. The tax subsidy is greatest for
those in the highest marginal tax bracket and is of little or no value
at all to those who do not owe income tax. Higher income individuals
are also better able to cover the costs of a high deductible, should
significant medical expenses be incurred. Additionally, those who do
not expect to have much in the way of health expenses will be attracted
to HSAs by the ability to accrue funds tax free that they can use for a
broad array of health related expenses that are not reimbursable by
insurance (e.g., non-prescription medications, eyeglasses, cosmetic
surgery). Those without substantial health care needs may also be
attracted to HSAs because they can be effectively used as an additional
IRA, with no penalty applied if the funds are spent for non-health
related purposes after 65. Young, healthy individuals may even choose
to use employer contributions to their HSAs for current non-health
related expenses, after paying a 10 percent penalty and income taxes on
the funds; a perk unavailable to those enrolled in traditional
comprehensive insurance plans.
The idea of lower premiums under high deductible policies also make
these recent reforms attractive to some employer purchasers. However,
the savings can only be modest for a fixed group of enrollees. Because
the majority of spending is attributable to the small share of
individuals with very large medical expenses, increasing deductibles
even to $1,000 or $2,000 from currently typical levels will not
decrease premiums dollar for dollar. The vast majority of medical
spending still will occur above even those higher deductibles,\17\
therefore premium savings can only be modest. The reduction in premiums
from moving to higher deductible plans cannot go far in encouraging
more employers to offer insurance or more individuals to take it up.
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\17\ LJ Blumberg and L Burman. 2004. ``Most Households' Medical
Expenses Exceed HSA Deductibles.'' Tax Analysts Tax Facts. Tax Policy
Center: Urban Institute and Brookings Institution. August; http://
www.urban.org/url.cfm?ID=1000678.
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The real premium savings from HSAs can occur by altering the mix of
individuals who purchase coverage. By providing incentives for healthy
individuals and groups to purchase HSAs with high deductible policies,
insurance risk pools can be further segmented by health status. The
average medical costs of those purchasing the new plans will be
substantially lower if the high risk population is left in more
traditional comprehensive plans. The practical effect, however, is that
the most vulnerable populations (the sick and the low income) are left
bearing a greater direct burden of their health expenses.
Another proposal, contained in H.R. 3901, and included in the
President's fiscal year 2005 budget,\18\ would make the premiums
associated with individually purchased high deductible health insurance
plans deductible from income taxation. The deduction would be allowed
regardless of whether other itemized deductions are taken. This new
deduction would be available for policies purchased with HSAs.
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\18\ Department of the Treasury. 2004. ``General Explanations of
the Administration's Fiscal Year 2005 Revenue Proposals.'' February;
http://www.treas.gov/offices/tax-policy/library/bluebk04.pdf.
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This policy would provide a non-group insurance product whose tax
advantage is almost as great as that available in the group market and
which is most attractive to those with high incomes and low health care
risk. Low cost/high-income purchasers, armed with yet another subsidy,
would be likely to find price advantages in most states' non-group
insurance markets. But as low cost purchasers leave the group market,
the average cost of those staying in the group market will rise, making
group insurance more difficult to afford for higher risk and lower
income populations. In addition, since small employers and higher wage
employees will be able to get tax breaks for the high-deductible health
insurance purchased individually in the non-group market even if the
firm does not provide coverage to their other employees, there will be
even less incentive for them to take on the hassle, expense, and risk
of offering insurance to their workers. The net result could be less
insurance coverage among small businesses in particular.
Legislation to create Association Health Plans (AHPs) and similar
employer-based risk-pooling entities have also been introduced
repeatedly over the years, most recently in 2003. Supporters of AHPs
hope the legislation will encourage professional and trade associations
to offer health insurance plans, thereby providing an alternative
source of coverage and new mechanisms for pooling health insurance risk
for employers. They expect such mechanisms to prove more attractive to
small employers who currently do not offer health insurance, thereby
increasing the number of workers with coverage. However, legislation
promoting AHPs generally includes Federal exemptions from some State
regulations governing existing commercial insurance products. As a
consequence, the new plans would likely be more effective than existing
commercial insurance products at segmenting health care risk for
purposes of setting premiums. They will tend to attract relatively
healthy individuals and groups, and will tend to increase premiums
faced by those remaining in the residual commercial insurance market.
Some (the relatively healthy) can be expected to gain from such
policies, while others (the less healthy) will tend to lose. Estimates
of the impact of AHPs suggest that while some employers will respond by
offering coverage for the first time, others will stop offering the
plans that they sponsored prior to reform. Accordingly, there would be
virtually no net change in health insurance coverage.\19\
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\19\ LJ Blumberg and Y Shen. 2004. The Effects of Introducing
Federally Licensed Association Health Plans in California. A
Quantitative Analysis. Report prepared for the California HealthCare
Foundation. www.chcf.org.
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New tax credits to subsidize the purchase of non-group insurance
policies will also tend to increase market segmentation. As is the case
discussed above with regard to deductibility of high deductible
policies associated with HSAs, new incentives that draw individuals out
of the employer-based market and into the private non-group market as
it is structured today, tend to exacerbate segmentation. This occurs by
virtue of the fact that there is less risk pooling in most states' non-
group markets than in employer-based markets. In addition, tax credit
proposals do not usually vary the amount of the subsidy provided with
the health status of the recipient; doing so is widely considered too
administratively difficult for the IRS. But as discussed earlier,
insurance premiums and outright access to coverage in this market do
vary substantially with health status. Consequently, a tax credit that
might cover a significant share of a premium for a healthy young person
would most likely cover a much smaller share for someone with a current
or past health problem.\20\ Risk-pool issues may be a primary factor in
the outcome of such policy proposals, with some individuals unable to
access the targeted market at all, and others potentially unable to
find an affordable premium/cost-sharing combination.
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\20\ LJ Blumberg. 2001: ``Health Insurance Tax Credits: Potential
for Expanding Coverage.'' Health Policy Briefs, The Urban Institute.
August; No. 1.
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V. CHALLENGES TO BROAD-BASED RISK POOLING
Some will suggest that we can prevent the selection concerns I have
outlined by providing greater choice of health insurance plans while
implementing a risk adjustment system that would spread the costs
associated with the high cost/high risk insureds across a particular
insurance pool. As already discussed, I do not believe that spreading
such costs within any particular insurance pool is sufficient.
Additionally, after many years of experimentation and study, the
technology available for accurately making risk adjusted payments to
insurers is still not as effective as we would like.\21\ Ideally,
insurers would be compensated for the excess costs of the care of their
unhealthy, enrollees, without compensating insurers for inefficiency in
the delivery of services. As the Federal experience with risk
adjustment of payments to HMOs under the Medicare program has revealed,
such a task is a difficult one. All empirical analyses to date have
suggested that the risk adjustment formula used to determine payments
to Medicare HMOs have exceeded efficient payment levels given their
healthier than average enrollees. Analysts have suggested that the best
risk adjustment approach would be a blend of prospective and
retrospective payments.\22\ But even in the most ideal of situations,
the maximum variation in expenditures that can be explained` is roughly
20 to 25 percent.
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\21\ JP Newhouse, MB Buntin, and JD Chapman. 1997. ``Risk
Adjustment and Medicare: Taking a Closer Look.'' Health Affairs. 16(5):
26-43.
\22\ JP Newhouse, MB Buntin, and JD Chapman, 1997. ``Risk
Adjustment and Medicare: Taking a Closer Look.'' Health Affairs. 16(5):
26-43.
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The technologies currently being used in the Medicare program which
account for slightly over 10 percent of the variation are still
considered inadequate, as evidenced by the dissatisfied reactions of
participating plans and their continued aggressive pursuit of healthier
enrollees. However, even if we could agree that the most recent
approach to risk adjustment works reasonably well in the Medicare
context, that does not imply that it would work sufficiently well for
adjusting plans in private markets. Key differences between Medicare
and private insurance are that Medicare coverage is virtually
universal--the whole population of elderly are in the risk pool, and
that the actuarial differences between plans are very small in
Medicare. In private markets, where actuarial values of different plans
can be quite large, and where people have the opportunity to opt in or
out of the market, risk adjustment becomes substantially more
difficult. For example, where variation in benefits is allowed--more or
less of a drug benefit, mental health benefit, etc.--selection can be
more targeted. In addition, when the actuarial values for plans differ
substantially, it becomes much more difficult to determine what is the
appropriate reference for any redistribution.
A very important issue with regard to employers and risk
adjustment, however, is less technical in nature. That is--is there a
strong incentive for employers to do effective risk adjustment and
maintain plan choice over time between comprehensive and high
deductible policies? Although most employers want to look out for the
well-being of all their workers, in a competitive environment they face
incentives to keep health care premiums down while keeping their
highest paid workers satisfied. If employers can keep premiums down by
having a healthier risk pool or leaving more of the costs of care
directly on the sick, then they will have more dollars to put toward
paying higher wages, thereby making them more competitive in attracting
and keeping the workers they would like to employ. HSAs may just
provide employers with an effective tool for responding to these
incentives, by placing a greater share of the health care financing
burden directly on the sick while the most valued employees can be
compensated via the tax subsidy. This may be a real improvement over
the past in the ability of employers to discriminate between the
healthy and the sick, because reducing the value of employer-based
packages in the past would have been potentially detrimental to all
workers, and this would have hampered employers' ability to attract
high wage workers. If this conjecture proves to be accurate, there may
be little incentive for employers to avoid having choice of plan
devolve to HSAs and high deductible policies being the only option. If
no other reforms are implemented, the lower income and higher cost
populations will then pay a larger share of their income toward medical
care than they did previously, perhaps impeding their access to
necessary services.
The most important challenge facing implementation of, a broad-
based approach to risk sharing, such as those that I have outlined, is
the financing required to implement the proposals discussed. Each of
these 3 proposals--increasing funding to high risk pools and making
their coverage more comprehensive; public reinsurance; and creating
purchasing pools with public subsidies for both the high risk and the
low income--would require new funding in a current context of enormous
Federal budget deficits. However, as a first step, each proposal could
be structured to limit benefits to particular groups, for example
individual purchasers and/or small groups. This would limit the size of
new revenues to be raised, but would also limit the benefits. In
addition, each proposal should lead to some private savings, as
insurance premiums go down, thereby decreasing the net costs to some
extent.
In conclusion, a wise person once said, when you find that you have
dug yourself into a deep hole, the first thing you should do to save
yourself is to stop digging. The tools that we have been using in
private insurance markets--segmentation by health care risk, and at
times, forced pooling within small enrollee populations--have gotten us
into this hole. It is time to set those shovels down (in addition to
policies which provide higher subsidies for higher income people), and
seriously consider an approach that would separate the excess costs of
caring for our most vulnerable neighbors from the decision to purchase
health insurance.