In discussions of health insurance, we hear a lot about pre-existing conditions, premium prices and rising health care costs. But why exactly does this affect your health insurance premiums?
Until the recent past people who had chronic illnesses, or those most likely to have chronic illnesses were the most likely to buy health insurance on the private market. The problem is that when you are actually chronically ill and don’t have health insurance, buying it can be difficult.
In most economic interactions, we assume that where there is a demand for a service, there are those who will supply that service at a price that a group of people who demand it is willing to pay. In economics parlance, we say that supply equals demand at a “market-clearing price.” At this price, both consumers and suppliers are satisfied with the price of health care.
Health insurance is different because of something we refer to as “moral hazard, which is when individuals take risks because they will not have to pay the entire cost that might occur from that risk. Moral hazard manifests itself when very healthy people decide that they don’t need any health insurance, while sick people are the ones who actually buy insurance. This makes the “portfolio” of health insurance holders the sickest members of society.”
Now, consider the perspective of an insurer in this industry. Your sickest clients are those who you have to pay the most to insure, while the healthiest individuals are those who you pay the least to insure. As an insurer, you would like to have fewer sick individuals on your rolls. If you could increase the average health of your rolls, you could increase your expected profit. Having an unhealthy average on your rolls decreases profit. Therefore, dropping as many unhealthy people from your rolls increases your expected profit.
This leaves the insurer with a delicate balance. If companies have trouble determining who is sick and who is healthy, they may set their premiums too low and fail to cover their costs. If companies raise their premiums, healthy people may drop their coverage, which reduces revenue and makes it hard for them to cover their costs! This is what has led many insurers to drop individuals with pre-existing conditions; it raises expected profits.
Health care costs have exploded in the United States. From 2000 to 2008, the amount that employers paid for workers rose by 25 percent , but employees saw none of that money in their take-home pay. Indeed, the median worker was actually earning less in 2007 than in 2000, after adjusting for inflation. This is because the 25 percent increase in payments for employees went to pay for the rising cost of health care. This has had a major effect on macroeconomic outcomes in the United States, as health care makes up 17 percent of all expenditures.
There are many potential explanations for the explosion in health care costs, and such noisy data, that economists don’t actually agree on what the exact reasons are. Although this is a hot topic for research, one thing is clear–the insurance market isn’t working for many Americans. The Affordable Care Act has been controversial for many reasons, but two main ideas are crucial for the plan to work. First, the ability for insurers to drop individuals because of pre-existing conditions is now illegal for most insurance plans. Second, the law seeks to achieve universal coverage via the individual mandate.
Because the people who would have foregone coverage are the healthiest people this should increase the overall health of the covered individuals and over time decrease the premiums, helping the sickest individuals to find coverage.
Gregory L. Torell is a 4th-year PhD candidate in economics at the University of Wyoming, where he studies environmental and natural resource economics, the economics of electricity and rangeland economics. He previously studied economics and German at New Mexico State University, receiving B.A.s in Economics and Foreign Language: German, as well as an M.S. in Agricultural Economics with a Master’s Minor in Experimental Statistics. He also studied macroeconomics and game theory at the University of Bern in Switzerland. He is always up for a good discussion of music, soccer, the latest book you read or your favorite podcasts.