The myth of too
little health insurance
By Randall J.
Pozdena, PhD
If one
believed the popular press, all of our problems with health
care would be solved if everyone had health insurance
coverage. It is popular to bemoan the fact that too many
households do not have health insurance, and that the poor
cannot afford to pay out of their own pockets for insurance or
care because of the high price of care.1
This is the fundamental fallacy of
modern health care policy. It myopically focuses on
ubiquitous, comprehensive health insurance as the solution to
the economical provision of good health care. This view
ignores the fact that poorly implemented subsidization and
overextension of health insurance are, in fact, the likely
proximate cause of the rising cost of health care.
The reason is simple. When properly
designed and applied, insurance provides an efficient means of
sharing risks. Risk sharing through insurance is important and
economically efficient when there are events that are rare,
costly and difficult to predict. Earthquakes, sudden death,
and house fires are such events, as is treatment for leukemia,
a stroke, or the unexpected complications of childbirth.
Insuring such events makes good economic sense because, though
rare, such risks are financially devastating. Consequently, a
rational, risk-averse individual will be willing to pay a
little bit, along with others, to be insured against the
consequences of such events. This in fact is the theoretical
reason for the existence of the insurance market – insurance
against rare, but financially catastrophic events.
In contrast, many health events are
so common and minor that they are likely to befall most
everyone in the population, with the consequence that there is
little advantage of risk sharing through insurance.
Specifically, the pro-rata cost of sharing the burden of
common and minor events through private or public insurance
will actually be greater than the cost of bearing it
individually because of the administrative cost of the
insurance. In such cases, there is no natural insurance
market. This is why routine house painting costs are not
insurable, but a house fire is.
However, when insurance premiums are
subsidized as a result of tax-exempt treatment of
employer-based insurance, demand for insurance of minor,
common events will increase. For example, one can be certain
that insurance policies to cover painting your house would
exist if their premiums were tax-deductible.
When insurance coverage is broadened
to include common events, there is no significant
risk-spreading function performed. What remains, however, is a
powerful, distortionary phenomenon economists call price
illusion. Price illusion occurs when the perceived price of
something does not reflect the true cost of that good or
service, and creates instead the illusion of low or even zero
cost. The effect of price illusion is that we as consumers
tend to not care about costs of the insured service, and
behave accordingly, because someone else will pay for it. It
is a basic precept of economics, however, that unless the
consumer cares about the price of a service when making an
individual spending decision, there will be no price
discipline in the market. After all, the providers of the
service have the opposite incentive – to make prices high!
The
tax-advantaged treatment of health insurance generally, and
the extension of this treatment to non-catastrophic care
insurance in particular, has dramatically increased the
importance of the price illusion in health care trends. In the
medical care realm, about 80 percent of all medical visits2
involve relatively minor, commonly anticipated
medical events. This includes such
events as seeking care for common colds, flu, infections,
minor injuries, normal pregnancy, etc. Though there is little
risk-sharing function performed by insuring such events, a
potent price illusion effect is created which results in the
false perception that the service is essentially free, at the
margin.3
Price illusion stimulates additional
spending, with no assurance that the additional spending is
cost-beneficial. Indeed, everything else being equal, the lack
of consumer discipline in the process virtually guarantees
that the additional spending will be excessive and
inefficient. As in the case of a group of diners who agree
beforehand to split the restaurant bill evenly, the insurance
of common health care services causes us to all spend more
than we otherwise would have. The result is over-spending,
yielding either over-consumption of services or inflation in
the price of services or both. The over-consumption effect
will dominate in markets where the supply of services is
responsive to demand, and inflation will dominate in a market
where the supply of services is relatively inflexible. In the
market for medical services, there are elements of both these
supply conditions, with the result that there is both
over-utilization and relative inflation of health care
services. By this line of reasoning, it is apparent that the
problem with American health care policy is not too little
insurance, but too much insurance and dominance of the price
illusion effect. American health care policy has virtually
extinguished consumer price discipline, with the result that
prices of medical services tend to inflate much more rapidly
than otherwise.
The inflationary effect of excessive
coverage can be documented by examining the pace at which the
unit cost of medical services has risen with the broadening of
insurance coverage. Even anecdotally, the coincidence of
increased coverage and medical services inflation is clear.
For example, in 1965 when Medicare was being debated, it was
widely lamented that the cost of a day’s hospital stay in 1963
was an outrageous $40. After 35 years of expanded Medicare
spending, the cost of hospital room and board (when billed
separately from nurse and medical services) now exceeds $500
per day in many urban markets. This is twice the cost that can
be explained by general inflation alone. Similarly, a simple
appendectomy that cost less than $75 in the 1940s cost over
$800 by 1989 and costs in excess of
$3,000 today. This is nearly four times the cost that can be
explained by general inflation alone. According to one analyst
of the Medicare program, failure to
anticipate the over-utilization and relative inflation caused
by Medicare resulted in a six-fold underestimate in projected
1990 costs.4
Using the available medical services price index data,5
the phenomenon can be demonstrated more comprehensively. Under
the pressure of expanded government and private insurance
coverage over the years, the price of medical services has
risen more than twice the rate expected from general inflation
factors. This is illustrated vividly in Figure 1.
The effect on utilization has
followed a similar path. The price illusion created by broad
health insurance or government health care provision has
caused consumers to increase the consumption of health care
services relative to other goods. Health care spending
increased from less than four percent of per capita gross
domestic product (GDP) to 12 percent in 1996 (and 14 percent
today). (See Figure 2.)
When the price illusion sparks such
runaway growth in spending, of course, it is virtually certain
that much of the growth is in the form of over-utilization
and/or low-productivity expansions in the features of the
services provided.
--------
1
Leighton Ku, “The Number of Americans without Health Insurance
Rose in 2001 and Appears to be Continuing to Rise in 2002,”
Center for Budget and Policy Priorities, September 30, 2002.
return
2
The highest proportion of medical costs is associated with
catastrophic care. return
3
In the extreme case, some medical events are not only
predictable, but intentionally precipitated, such as normal
childbirth, or well-known consequences of other, voluntary
behaviors. Insuring these events is particularly problematic,
because the insured person can buy insurance knowing
beforehand that the event will happen with near certainty or
high probability. return
4
Sue Blevins, Medicare’s Midlife Crisis (CATO Institute; 2001),
p. 54. return
5
The Bureau of Labor Statistics publishes medical price index
data. There is debate whether this index adequately (or
excessively) accounts for changes in the quality of medical
services. return
This article is
excerpted from the NPRI study, First Do No Harm: Why
American health care policy is failing, and how to fix it,
available on the Web at
www.npri.org/mgraphs/1stDoNoHarm.pdf .
