I’m a bureaucrat at a health insurance company which most of you have never and will never hear about. My job is to be a subject matter expert on a fairly arcane set of knowledge. I have seen some posts and some great comment threads at Balloon Juice where great questions are being asked and basic mechanical knowledge would be very useful. I will be writing a series of posts over the next couple of weeks/months that attempts to explain why a profit seeking insurance company does what it does.
And yes, before I get started, I agree with the vast majority of the commenteriat here that absent massive path dependency and being able to make policy behind a veil of ignorance, I would not choose the US model or the modifications to the model that are being made by Obamacare. I would have chosen a far more comprehensive single payer system that is not a kludge of multiple previous kludges. However, that is not the world that we live in, so I am assuming profit seeking insurance companies will be around for a while.
Why do insurance companies charge deductibles, co-payments and co-insurance? What is the point of three forms of making the buyer of insurance pay? Why wouldn’t there be a single form? What are the incentives and how do the different cost share payments save the insurance company money?
These three types of pocket payments have slightly different purposes but they all serve to minimize costs for the health insurance company. One things that we need to remember as we go through the mechanics of non-universal health insurance along the lines of either Canadian Medicare or British NHS is that members/buyers of insurance know way more about their health than the insurers. That knowledge fuels the buyer’s ability to seek the best deal. This is known as adverse selection.
Let’s look at JC for an example. A mid-40s something male still on average has reasonably low health care costs without too many high expense outliers. Someone of his general demographics is still in the sweet spot for insurance risk as the long term chronic conditions of late middle age and old age aren’t too common yet. John knows he is a klutz and that Steve is plotting to kill him slowly. So if he selects a plan with low cost sharing because he knows that in the next year he needs to worry about a repeat of the mop incident or the first failed attempt on his life by Steve. That is unusual and therefore valuable information for an insurance company as John would have self-identified as riskier than typical for someone his age.
Deductibles serve two purposes. The first is to transform insurance from being purely pre-payment of average medical expenses for a particular population into an insurance product. Insurance is the payment of defined sums for protection against uncertain losses for an individual. The first purpose of deductibles is to get the insurance company off the hook for the first chunk of expenses.
A zero deductible plan is very attractive to people who know that they have major medical expenses coming their way. A very high deductible plan is attractive to people who anticipate very low health care expenses due to their general good health or belief in their own invincibility. An employer group that offers a $500 deductible plan and a $2,500 deductible plan to its employers will not see random selection of those two choices by its employees. Most of the time, older, sicker employees will choose the lower deductible plan, which is extremely valuable information for the insurance company. They expect high usage of expensive services, so premiums are higher. Conversely, the high deductible plan is more attractive to the younger, healthier and typically a more male population that statistically don’t use expensive services all that much. Bigger spreads between deductible amounts allows for insurance companies to aggressively identify adverse selection risks and then appropriately price that risk.
Co-payments are fixed dollar amounts that members pay for services that don’t apply to deductible sums. There are two reasons for co-pays. The first is to make a service slightly less expensive for the insurance company. This is a minor factor. The main factor is to add a marginal cost for a service from the member’s perspective after a deductible has been satisfied. This is supposed to make members slightly cost sensitive. A $100 co-pay for an MRI is supposed to get the member to question whether or not they really need an MRI or whether the no co-pay X-ray is sufficient. Co-pays for cost sensitivity purposes are extremely common for prescription drug benefits where generic or cheap brand name drugs have nominal co-pays, while patented drugs that have reasonably available and effective substitutes have very high co-pays.
Co-insurance is a percentage of costs that a member is responsible for after their deductible has been satisfied. The primary purpose is to make the member become extremely cost sensitive. For instance, a 20% co-insurance for a non-complicated labor and delivery when my wife gave birth to Reproductive Success #1 and #2 could have put me on the co-insurance hook for roughly a paycheck at the local mid-wife center or a couple of paychecks at the hospital. These type of variable marginal costs for identical services are designed to get people going to the cheaper providers or to eliminate the less essential services.
To review – deductibles are designed for adverse selection identification and effective repricing of risk while co-payments are designed to steer people to cheaper option with fairly simple incentives. Co-insurance is designed to get members to price compare between a variety of providers for a single array of services. Finally, total out of pocket exposure is often capped because there is no reasonable ability of people to finance $30,000, $40,000, or $50,000 in medical expenses from a single incident.
The more cost-sharing through deductibles, co-pays and co-insurance, the less risk the insurance company bears, and the more risk the individual carries on their own. A high deductible, high co-pay, high co-insurance plan is an adequate plan for individual members who either have significant free cash flow OR have a high degree of confidence in their health AND have some ability to access assets in an oh-shit hit by a bus scenario. High deductible, high co-payment, and high co-insurance plans will be the dominant plans on the Catastrophic and Bronze exchanges. Conversely, low deductible, low co-payment and low co-insurance are “rich” coverages that are used by people who can either afford a high premium but few surprises, OR know they need to use a lot of medical resources.
The next post will talk about how insurance is regulated.
NB: Actually going through all the Balloon Juice categories for the first time is pretty damn awesome