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Obamacare vs. Arithmetic

Arithmetic wins, every time.

by
Charlie Martin

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November 2, 2013 - 10:48 pm
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Back in 2008, I wrote one of my first pieces for PJM: “Today’s Health Insurance Ain’t Insurance.”  I just re-read it and it stands up pretty well: today’s health insurance still ain’t. Have a look at it, as it has some more detailed explanations for the points I’m going to make in this article, but the point is this: there’s basic mathematics behind all real insurance, and while actuarial math can get pretty hairy, we don’t need it to see the underlying and essential flaw of the whole approach taken by the Affordable Care Act.

At the heart of it, insurance is a bet. You are making a bet with someone else that some bad thing will happen to you, while they’re making a bet that it won’t. If you buy the simplest and cleanest kinds of insurance, like term life, you are betting that you are going to die during the term of the insurance, and the insurance company is betting you won’t. (“Whole life” and “universal life” policies are more complicated things that mathematically act like combining a term life policy with an annuity. This is where the math can get hairy, but you pretty much find out what you need to know when you realize an insurance company would far rather sell you one of these policies than term life and a separate annuity.)

All insurance is based on a really simple equation called expectation value, or more commonly risk. In life insurance, you start by deciding how much money your survivors need if you were to fall over tomorrow. Let’s say it’s $100,000. (Your spouse can get a job.) So the amount at risk for the insurance company is $100,000. That’s called the hazard, H. They look at your your age, your sex, your health, and possibly your profession or hobbies (base jumping? Race car driving?) and come up with a probability that you will die during the term of the insurance. That’s a number P where 0 ≤ P ≤ 1. Then they compute the expectation value R of that $100,000 as

R = P × H

The way to interpret that is: if you sell enough insurance policies to people with the same characteristics, the insurance company can expect to pay out about R dollars for every $100,000 worth of policies sold. I just went online, and as a 58-year-old man with diabetes, the best rate I found was $495 a year. That would actually be a little more than the actual risk; insurance companies need to have some room for runs of bad luck, and they need to have some margin over that to pay for all those people running the insurance company and some profits for the stockholders. (Which, contrary to what you hear from the usual suspects, isn’t very large — Aetna, for example has profits between 2 and 6 percent.) So the real premium for a term life insurance policy is a little more than just the expectation value. How much depends on a whole bunch of things, so let’s just say x. Your total premium is going to be R+x and we know x > 0.

When we look at what we call health insurance now, though, that all breaks down, because many of the things that are covered happen — colds and flu, childhood illnesses, and so on — with probability near 1.

Guess what? If P is about 1, that premium is going to be the total cost plus x. Always. No matter what.

We got away with the current scheme for as long as we did because, dating back to Harry Truman’s administration, we let companies buy their group health insurance using pre-tax dollars. In other words, they got a pretty substantial discount for buying health care for their employees instead of paying them more.

Now, when you give people an incentive like that, they’re going to do more of it; what used to be “major medical” starts adding regular doctor visits and such. At the same time, the insurance companies want to control their costs, so they started adding more administration to the whole thing. That increases x but it doesn’t change the relationship.

What does change the relationship is that we start to run into something Milton Friedman called “Gammon’s Law,”  which originated with a study of Britain’s National Health Service done by Dr. Max Gammon. Friedman called it the Theory of Bureaucratic Displacement:

In a bureaucratic system, increases in expenditure are paralleled by a corresponding decrease in production.

Translated from the economist-ese, that means in a bureaucratic system, the more you spend on something, the less you get of it.

Gammon’s original work in which he identified this found the correlation was very nearly perfect: as the number of pounds spent on the National Health System increased, the number of hospital beds declined. The correlation was -0.99.

Aside: for those of you who don’t eat and breathe statistics. Imagine you have a loaf of sliced bread. You weigh the bread, then take out a slice, then weigh it again; keep taking out slices of bread and re-weighing.

The correlation between the number of slices taken out, and the weight of the remaining bread, will be around -0.99.

Why does this happen? There are at least a couple of reasons. As more money goes into the bureaucracy, there’s more pressure to make sure it’s being spent well, which means more forms, more auditors, more independent review boards. All of that takes time and money, and that time and money are being taken away from what used to be the goal.

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Top Rated Comments   
Employer provided health insurance started out as a way around WWII wage controls. It probably was around for higher level employees even before WWII, but extending it to production workers was a creature of the wage controls.
47 weeks ago
47 weeks ago Link To Comment
Please don't interpret the following as a statement of support for Obamacare. It's a terrible law. But I do support the idea of universal coverage, and the idea of a mandate as the best way to get there. Here's why:

In every other market, you get denied the good or service if you can't pay. So, if you don't get collision insurance on your car, and somebody t-bones you, and you have no money, you'll be taking the bus for a while. No problem--you decided to take the risk.

The problem with this in the health care market is that we as a society are not willing to let people die because they were stupid and didn't get catastrophic insurance coverage. We don't wheel the gurney out to the parking lot and dump you on the asphalt when you show up in the ER with a heart attack and no money. We treat you anyway, and almost everybody supports that decision.

But that means that the stupid people (or, to be fair, the people who simply can't afford the insurance and have to take the risk) get to free-ride off the rest of us, because the hospital raises its rates to cover its bad debts.

Now, a mandate isn't the only way to solve this problem. A tax works quite nicely, too. But you have to do something, because the one thing we don't want is for free-riding to show up in opaque pricing. We don't want opaque pricing anywhere, and this is a pretty big source.

Now, there's a second problem that's a bit more morally dicey. We won't throw you out of the emergency room, or the cath lab if you need a stent, or even the operating room if you need a double bypass right away, as long as we're talking about emergency services. But we're perfectly happy to deny you chemo for your cancer if you can't pay, because that's not an emergency. This doesn't make a lot of moral sense, and it doesn't make a lot of economic sense when the cancer patient eventually shows up in the ER in some kind of crisis.

Mandates--and mandatory minimum coverage--solve this second problem, too. Again, you can do it with a tax, but the mandate works pretty well and everybody knows what they're paying for that way.
47 weeks ago
47 weeks ago Link To Comment
Imagine a baker who bakes that loaf of bread takes one piece and saves it for his wife. He then has children and bakes a second loaf and third loaf so he can give a slice to his children. After years of meticulous baking he makes a dozen loaves for his grandchildren. Then a hippie takes over the government as dictator.

He grabs half the loaf to give to people who don't pay anything. He takes half the slice from the children and grandchildren. The baker meets with the butcher and the candlestick maker who agree that they have worked hard to provide. The hippie dictator calls them millionaire terrorists, says the family is racist and threatens to close them down, spies on them and sics the IRS on them to prosecute and torment them.

Those who pay nothing "deserve" free stuff and those who are providers deserve ridicule, derision and hate.

The butcher, the baker and candlestick maker don't know where to turn for help.

So they pray.

And THAT is considered the worst offense of all.

Because the hippie went to church every Sunday for years as well. And his pastor bellowed out, God Damn America!

The butcher, the baker and candlestick maker all agree.

That pastor got his wish.
47 weeks ago
47 weeks ago Link To Comment
All Comments   (79)
All Comments   (79)
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Why can't arithmetic be compassionate and understanding? I demand a new and gentler math. 2+2 will equal 5 in my world.
45 weeks ago
45 weeks ago Link To Comment
Great article. It not only demolished the conceit of obamacare, but the suggested alternatives, moving insurance away from the business to the individual, making insurance real insurance again rather than paying for routine care, and HSA's to pay for routine care to solve the 3rd party payment problem, are all excellent ideas.
47 weeks ago
47 weeks ago Link To Comment
THIS is what your President is like behind closed doors America.

'I'm really good at killing people': New book claims President Obama bragged to aides about using drone strikes.

I bet the Nobel Peace Prize Awards committee are so proud.

http://www.dailymail.co.uk/new...
47 weeks ago
47 weeks ago Link To Comment
I guess there's a step here that I need to clarify. For whatever reasons, we don't allow people without insurance to just die. If we did, then a mandate wouldn't be necessary. As it is, though, someone somehow is going to pay for catastrophic care; given that, it seems the least obtrusive way to cope is a mandate.

Note, by the way, that this catastrophic-care mandate with the insurance obtained on the open market is cribbed directly from Milton Friedman, so if it's creeping socialism it at least crept in from a fairly reputable source.

The problem of how you keep the mandate from being expanded is one I don't have an answer for.
47 weeks ago
47 weeks ago Link To Comment
Charlie,

I'm shocked and more than a little dismayed at the collectivist tripe coming from you.

When someone goes to a hospital and can't pay, but the hospital treats them anyway, who pays? You said, "we all pay." That's factually untrue.

The hospital eats the cost. You and I understand that they crank up the prices for everyone else to cover that cost, or they dip into some philanthropic fund to pay. I don't pay, because I've never been to a hospital. Just like millions of healthy Americans, I really haven't been burdened.

My assumption, and perhaps its erroneous, is that in many cases the hospital sics a debt collector on the person who can't pay. In some cases, they'll never collect, but I suspect in many cases they get some percentage back.

Let's take it a step further. Why can't people pay? There's been some articles from Reason showing a group of doctors in Oklahoma who are running their own private practice who publish their fees. In some cases, a local hospital was $11K for something these doctors only charge $3K.

Why? Insurance. Insurance has completely distorted the market. When people don't have to care how much they pay for something, because what they pay is the same regardless of what it costs, then hospitals are going to crank up costs. If the recipients of the product actually had to shop around for a good price, the market would function properly.

Add to that nonsense the fact the government has already been tinkering with the healthcare industry - mandating insurance cover certain expenses at hospitals - and you see where this disaster started.

What in the world did humanity do prior to the 1980's, Charlie? How in heaven did humanity survive without mandated coverage?

More importantly, how can you support a government mandate, Charlie? I thought you were one of the good guys. This is the most anti-American thing I've ever seen you post. I can't help but shake my head the whole time I'm writing this. You've betrayed your readers.
47 weeks ago
47 weeks ago Link To Comment
"The hospital eats the cost. You and I understand that they crank up the prices for everyone else to cover that cost, or they dip into some philanthropic fund to pay. I don't pay, because I've never been to a hospital. Just like millions of healthy Americans, I really haven't been burdened."

You're burdened if you have insurance, because when the hospital jacks up the price to cover the bad debts, the average cost to the insurer goes up, too.
47 weeks ago
47 weeks ago Link To Comment
And as long as you never, never ever, want to obtain services from a hospital, or a doctor connected to a hospital, or have a lab test done at a hospital, or buy *any* kind of insurance from any insurance company that covers health insurance or reinsures health insurance or provides bad debt insurance, and never ever go to a public hospital, and don't pay taxes (because for-profit hospitals chanrge those off against revenue and so the bad debt loss increases their costs and reduces their tax burden) then you might have a point.

Otherwise you're just demonstrating a lack of clear thinking.
47 weeks ago
47 weeks ago Link To Comment
Early on I recommended we treat medical care like basic foodstuffs - which are exempted from sales tax in most localities. If it's essential, don't tax it. It would eventually get employers out of the business - since it's not their business and they've no special competence.

Granted, taking a sixth of the economy off the table is hard for the politicians to come to terms with. But they caused this mess - so a little dieting is a small price.
47 weeks ago
47 weeks ago Link To Comment
That's essentially right: right now, *some* people get to pay for health care wih pretax dollars. Some don't. That is a root cause of the whole mess.
47 weeks ago
47 weeks ago Link To Comment
I take issue with point #3. NO mandates - and no guaranteed healthcare. If you choose to take your chances then you accept the consequences.
47 weeks ago
47 weeks ago Link To Comment
See above. That will only work when we let people who show up with a critical illness just die. Until then, we have to tink of some way to pay for it. Right now, we handle that by making it a bad debt to the hospital.
47 weeks ago
47 weeks ago Link To Comment
Sorry, but there won't actually be a market until doctors are forced to compete, and that will only happen after government licensure is abolished. Nice reforms, though.
47 weeks ago
47 weeks ago Link To Comment
I have to have a licence to do my job and sure as hell is hot, I have to compete everyday all day to make my bones. Now if I could have the payer dictate who they will do business with, then your argument would have merit. It is the collusion between the doctor and the insurance company that is screwing the buyer...
47 weeks ago
47 weeks ago Link To Comment
Well, Charlie, there's a lot of ambiguity in life that isn't directly translatable to mathematics. For example, according to the Stanford Encyclopedia of Philosophy, it's not "torture" when you say yes. Apparently "torture" becomes just consensual B and D in San Francisco provided the terrorist being tortured says yes: perhaps the Geneva codes should be changed to provide for implied consent to water boarding when specific empirical conditions are satisfied? So, take the individual mandate that whips you by the IRS for failure to purchase cotton from Blue Shield INC. In other words, a group of people I'll call Bubbas get whipped, treated like slaves, for failure to purchase cotton. Of course, the math won't work because of adverse selection and doctors opting out of supplying health care to Blue Shield cotton purchasers. At least with real slavery and the cotton gin the costs of cotton came down. Well, the democrats are already suggesting a law mandating that all doctors provide services to those Blue Shield cotton purchasers to off set the adverse selection. In other words, the doctors are going to have to pick cotton for Blue Shield or get whipped so the Bubbas can purchase those cotton garment products from Blue Shield. And since it was democratically done with consent, it's not slavery or indentured servitude. And given that "real" slavery still exists in the world, I would venture a guess that math must still work.
47 weeks ago
47 weeks ago Link To Comment
What?
47 weeks ago
47 weeks ago Link To Comment
"We got away with the current scheme for as long as we did because, dating back to Harry Truman’s administration, we let companies buy their group health insurance using pre-tax dollars. In other words, they got a pretty substantial discount for buying health care for their employees instead of paying them more."

This doesn't jibe with my recollection. After all, employee salaries are a business expense and are therefore effectively pre-tax dollars as well.

The story I remember is that employer health insurance started because it was a way around WW2 wage controls, and therefore a way to compensate workers higher than the controls allowed.

The big deal now is that group health insurance doesn't count toward employee (not employer) taxable income, which (as you point out further down-post) gives the employee a lot more bang for the buck.

Do I have this right?

You have, however, hit the nail exactly on the head with respect to why first-dollar health insurance isn't really insurance. I'd only add that, in addition to Gammon's Law, not only does bureaucracy chew up more and more money when insurance is merely acting as a fulfillment service for medical payments, it has the obvious effect of being opaque to consumers who, even though they may not want to know what stuff costs, need to know what it costs if we want to fulfill the public policy goal of making medical services cheaper.

Note that your idea #3--minimum coverage standards--is in Obamacare and is a big part of the problem. I agree with you that some kind of minimum standard is necessary, but there's a horrible governance problem implicit with them: It's an easy point of attack for every interest group that wants to promote some specific agenda by getting their pet peeve covered, and it's equally tempting for providers of some service, who can see obscene increases in demand for their service if it's in the mandatory set.

Using the minimum coverage standards to force maternity coverage on men and infertile women, and force mental health and addition services on people who are pretty confident in their own stability, is just (pardon the adjective under the circumstances) crazy. So how you balance the benefits of minimum coverage mandates against the potential for abuse needs to be thought through a lot more carefully than it was in ACA.
47 weeks ago
47 weeks ago Link To Comment
Art got it right in one -- sorry, I should have been clearer. During the Truman administration, there were wage controls on.
47 weeks ago
47 weeks ago Link To Comment
Charlie, am I right that the tax advantage today is for the employee, not the employer? And couldn't an equal tax advantage be gained if the caps were taken off of health savings account contributions?
47 weeks ago
47 weeks ago Link To Comment
I think it's both: it's not taxable income to the employee, and it's a deductible cost to the employer.
47 weeks ago
47 weeks ago Link To Comment
Yeah, but just increasing the employee's salary is equally deductible--more accurately, it's a 100% adjustment against income as a business expense. So a business could pay an employee more, but then the employee would lose some of that in income taxes. On the other hand, if the employer could dump the amount spent currently on insurance into an HSA (which you can almost do today), it's not taxable income. Bottom line: no difference to the employer between paying for a group plan, funding an HSA, or just paying the employee more, but a big difference to the employee.

I'm picking at this because there's something fundamentally unfair about what ACA is doing to the individual insurance market: A very small number of people (those who have individual plans already or who are being forced to get individual plans under the law) are bearing the entire cost of paying for the previously uninsurable, who of course are benefiting hugely from ACA. A fairer system would spread that burden across everybody with insurance and include those who have employer-based group coverage.

Group insurance is, as a practical matter, not community-rated, because employees tend to be younger and healthier than the population forced to use individual insurance. If you dumped all the employees who were currently group-insured into the individual markets, the cost to insure the old/sick would get amortized across a much larger pool, and the premium increase would be borne equally by everybody.

This would obviously be a rude shock for the 49% of the US population that has group insurance, but it has three really nice advantages:

1) Assuming you think that the legacy system is unfair, and the ACA replacement is even more unfair, this is about as fair as you can get.

2) It has the nice property of almost certainly extinguishing first-dollar insurance from the market and going to a system where insurance is for insurable events. That puts huge downward pressure on routine care costs, which are about a third of all expenditures.

3) It doesn't screw up the labor market, because employers and employees both get the same tax advantages by spending the same amount of money on health care, even though it's going into an HSA instead of group insurance.

Of course, we could just return to the status quo ante and subsidize the state risk pools through a tax and do just as well. But I'm kind of assuming that the days of "repeal and replace" are now behind us, and it's on to "improve and tinker, before we all drown".
47 weeks ago
47 weeks ago Link To Comment
Employer provided health insurance started out as a way around WWII wage controls. It probably was around for higher level employees even before WWII, but extending it to production workers was a creature of the wage controls.
47 weeks ago
47 weeks ago Link To Comment
I have often wondered whether or not a better solution might be some sort of term life insurance product. And let me explain:

The real problem is getting people to put a value on the health care they receive. This reveals itself in the out-sized expenditures in the last 5 years of life where most costs are 3rd party-paid from Medicare. Consider this- at age 18 everyone is mandated to buy, let's say, a $2 million (or whatever the actuaries can determined to be the number that will cover the expected health costs of that 18 year old until death) term-life policy. This policy is always renewed at the same premium rate, and the pools consist solely of people of the same age. The owner of the policy can pay for his medical care out of pocket, or he sell a fraction of the policy's payout to cover costs during his life- it is up to the owner to make the decision what to do. If he doesn't want to sell the policy to pay for expensive, life-extending care, but would rather gift the policy to his heirs, then he can do it.
47 weeks ago
47 weeks ago Link To Comment
An excellent explication of insurance, Mr. Martin.
47 weeks ago
47 weeks ago Link To Comment
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