Insurers in a free, unregulated market with imperfect information and very expensive right hand tails of risk distribution will quickly converge to offering really bad coverage. This is a sub-optimal for everyone involved. It hurts people who need good coverage. It hurts society in general as risk is not distributed efficiently. It hurts hospitals as it guarantees more bad debt. And it hurts insurers as they are giving up potentially profitable sales in order to protect themselves from a risk dump.
There will be some mathematical intuition required for this post.
Let’s imagine a world that does not involve insurance. Let’s imagine Abe and Bob both sell furnaces to the same small town. They both make a good living. Their products are fundamentally similar. Bob’s furnaces start faster and warm the house quicker, Abe’s machines run quieter. Their current advertising budget is limited to a quarter page Yellow page ad and brightly painted work vans with their phone numbers on it. The market for new furnaces in their region is effectively saturated and it is a steady business.
In the first year, both Abe and Bob make $100,000 in net profits. In the second year Mark the Marketeer offers to sell $10,000 of advertising to Abe and Bob. If one chooses to advertise and the other does not, the advertising furnace guy gets an additional $20,000 in profits but spends $10,000 in advertising. If they both advertise, Mark gets $10,000 from each and there is a decrease in profits of $10,000 from each of Abe and Bob. The pay-off matrix is below:
Let’s work through the decision tree. They start in green. Mark makes the pitch. If Abe advertises, his worst situation is $90,000 and his best is $110,000. If he does not advertise, his worst situation is $80,000 and his best is $100,000. If Bob advertises, his worst situation is $80,000 and his best is $90,000. The same applies in reverse to Bob.
If there is neither regulation nor collusion, both of them will advertise. They will see a decline in profits as Mark acts as middleman. Once advertising starts, the logic has both of them advertising frequently in order to protect their own marketshare. They are in a collective action problem.
Insurers are in a collective action problem. Bad benefits drive out good benefits. We talked about this with AIDS formulary design in the summer of 2014:
Once one plan in a market decides to make themselves as unattractive as possible, every other plan has to either follow suit in making themselves unattractive or be willing to take on massive health costs as they become the preferred plan for HIV positive individuals. At that point, there is a local death spiral as the attractive plan has to raise premiums to cover costs which drives them away from the Second Silver subsidy determination point, which then drives away cost sensitive but fairly healthy individuals from the plan. So a region will see either the “nice” plan become a “nasty” plan as a self-defense measure or that “nice” plan will leave the market so the new baseline is “nasty”. It is Gresham’s law for health insurance.
This problem is solvable. The unregulated equilibrium is for plans to be ugly and for plans to spend a lot of time and money on finding ways not to cover people. Regulation is the key. It sets a different set of parameters or at least it governs the depth of ugliness a plan is allowed to descend to. Essential Health Benefits and actuarial value floors limits how much socially counter-productive but firm specific rational behavior can occur.
And once those counter-productive cherry picking tendencies are curbed, a much larger market emerges. That market, once insurers figure out how to price it properly, can be profitable as hell even as it covers millions of more people.
rikyrah
Your first sentence says it all. Makes waste of the GOP mantra of the “free market”???
Baud
If the free market produces it, it can’t be bad. #randian
evodevo
But, but, but this is TOO COMPLICATED for me to understand, therefore I want a simple misleading meme, phrase, mantra I can repeat over and over that will sooth my conscience about killing people !!
Jerry
With the talk of “Medicare for all” being brought up again, can you speak to that? Have you already in the past? If so, can you please direct me to that post or posts?
This post is great because it explains, in a very clear way, why an unregulated health insurance is so bad. I try to argue this point with others, but I usually fuck it up. The AIDS coverage is the example that I’m looking for. Thanks again, Mr Actuary Tables.
evap
Prisoner’s Dilemma applied to selling stuff — awesome!
different-church-lady
The obvious solution is to run Mark the Marketeer out of town on a rail.
liberal
One of many reasons single payer is superior.
Baud
@different-church-lady: Mark will happily sell you the monorail that he would be run out on.
liberal
@Jerry: Medicare for all is bad because it makes baby centrist Jesus cry.
NotMax
Succinct description of the gerbil that drives the flywheel of insurance companies.
Baud
@liberal: Jesus doesn’t like the competition.
Another Scott
Excellent explanation, and an excellent baseline for asking “what if” questions.
E.g. we know there is no such thing as a “free market”. People installing furnaces are “reps” for big companies with restricted service areas. They also have to meet various insurance/licensing/safety regulations. There are all kinds of rules and regulations that come into play that we don’t think about usually, but it’s not an “every man for himself, take what you can” marketplace. Entrenched players have huge advantages because (among other things), they know how the system works and know where the lines are.
And there’s the big difference: If my furnace goes on the blink, I can think about replacing it with a heat pump or a pellet stove or electric baseboards, or I can put off the repair for a few months over the summer while I think about my options. If I get hit by a bus, or get a serious infection, or my blood sugar goes crazy, or I hear voices telling me to fly an ultralight airplane to Mar-a-lago and demand to talk with Ivanka, then that can’t wait. I don’t have a choice about getting treatment later, and I can’t shop around and get bids from Abe and Bob. And I won’t know what it will cost before I make the call or drive to the doctor…
While we can learn good lessons from thinking clearly about simple economic models, we can’t let it determine policy when the “markets” are very, very different. It would be nice if the people writing policy would not let pablum guide them, and instead start with things like your post(s).
Thanks.
Cheers,
Scott.
different-church-lady
@NotMax:
Mathguy
This is a great example. I’ll be using this in class. Thanks!
David
I believe the payoffs in the off-cells are reversed; you have the surplus accruing to the non-advertiser.
Sab
@liberal: Is single payer the panacea?I thought the Dutch had single payer and went back to insurance because it works better.
The Canadians like single payer, but they are unusually placid.
JGabriel
Wait, wait, I know this one … the train is at the North Pole and never left the station. And Col. Mustard did it in the Accounting room with the abacus.
David Anderson
@Sab: single payer is a viable solution. Clear regulation and standardized required options are another.
Buskertype
Semi O/T:
A while back you said you were working on a piece about UPMC vs. Highmark… are you still working on that, or did I miss it somehow? Thanks!
Sab
@David Anderson: Thanks. With you I am always learning.
Villago Delenda Est
But (whine) that means (whine) that we’ll have to look (whine) beyond the current fiscal quarter!
David Anderson
@Buskertype: this is about 80% of that piece that I have not written yet.
https://balloon-juice.com/2017/03/17/swpa-under-ahca-because-of-upmc/
Buskertype
@David Anderson: thanks!
DHD
@Sab: To the extent that there are problems with the Canadian system they don’t have a lot to do with it being single-payer (although be aware that “single-payer” is a massive simplification, we really have 11 public payers + a bunch of supplementary private insurers). My suspicion is that the reason the Dutch have a mixed system has more to do with free-market ideology (what is called “liberal” in Europe to the great confusion of Americans) than anything else.
It appears that the Netherlands actually spends more per capita on healthcare than Canada despite being about the physical size of the Greater Toronto Area. On the other hand you can probably find a family doctor there: http://evidencenetwork.ca/archives/20621