This essay was also published in economics21
Roughly one-quarter of the nonelderly adult population in the United States has a pre-existing chronic condition. In principle, obtaining private health insurance with an experience-rated premium tailored to a consumer’s expected expense for the year would provide a welfare improvement to facing high and uncertain medical spending if uninsured, but society may not like the inequity of those with pre-existing conditions paying premiums as much as 10 times higher than the premiums paid by healthy people. Moreover, even for healthy people, the uncertainty of future increases in one’s premium resulting from potentially developing a chronic health condition is something that risk-averse people should want to avoid.
The fundamental hindrance to achieving the goal of pooling comes down to the following policy conundrum: How can policymakers get younger, healthy adults to essentially cross-subsidize older adults with pre-existing chronic conditions? There are ultimately two separate methods policymakers could adopt to tackle this problem: a set of regulation-oriented arrangements that would compel cross subsidies, and a market-oriented arrangement that would establish voluntary cross subsidies.
This market-oriented arrangement of voluntary cross subsidies would be based on guaranteed renewability of insurance and would require a modification of the tax code to extend the tax break for health insurance beyond the employment-based market into the individual market. If that tax inequity were removed, people would obtain guaranteed-renewable insurance while young and healthy, and the pre-existing condition problem would eventually barely exist. This market-oriented arrangement could be superior to the set of regulatory arrangements that have been either tried or suggested to help people with pre-existing conditions.
The Regulatory Arrangements
The following four regulatory arrangements are widely proposed, or used, in attempts to cross-subsidize people with pre-existing conditions.
The first arrangement is simply a government single-payer model in which everyone has the same amount of coverage financed by government tax revenues. In this situation, there are cross subsidies both from high-income people to low-income people and from people without pre-existing conditions to people with pre-existing conditions. While some view this as the simplest, most elegant arrangement, there are important negative consequences. One is the “deadweight loss of taxation” from lower economic output caused by the higher tax rates needed to finance this coverage. Another is the potential inefficiency from government-administered provider prices, which includes the regulator’s costs of determining appropriate prices based on underlying marginal costs and the potential mismatch between prices and marginal costs, owing to either naïve estimates for costs or inappropriate “regulatory capture” of the price-setting system.
The second arrangement is the employer mandate model, in which employers are simply required to offer coverage to workers. Employer mandates set up cross subsidies from low-income people to high-income people (through the regressive tax exclusion for employment-based insurance) and from people without pre-existing conditions to those with pre-existing conditions (because the reductions in worker wages to finance the employer benefit are unlikely to vary by individual health status). In addition to the inequities and inefficiency of the tax exclusion itself, there are also likely important labor market distortions resulting from this mandate on employers. These might include increased unemployment resulting from higher total compensation costs for employers, especially for workers near the minimum wage, where higher benefit costs cannot be offset by lower wages.
The third regulatory arrangement is a community rating provision, making the premiums people pay independent of their pre-existing conditions, coupled with a guaranteed-issue provision, requiring insurers to sell their policies to anyone regardless of pre-existing conditions. The adverse selection by those with chronic conditions essentially needs to be offset by a combination of tax subsidies for the premium and tax penalties for the failure to purchase health insurance. For instance, the state health insurance exchanges set up by the Patient Protection and Affordable Care Act (ACA) couple generous subsidies with an individual mandate’s tax penalty. Interestingly, Medicare Part D’s prescription drug coverage is essentially community-rated insurance, and similarly mitigates adverse selection by relatively large subsidies and a late enrollment penalty equal to 1 percent of the premium per year.
A final regulatory arrangement couples private experience-rated individual coverage with high-risk pools to provide coverage to uninsurable people who cannot pass medical underwriting to obtain a private plan. This was essentially the arrangement taken by roughly two-thirds of the states before the ACA’s passage. Historically, these state high-risk pools were either underfunded or expensive. If pools are underfunded, people with chronic health conditions still pay considerably higher premiums than those without chronic health conditions. And if pools are adequately funded by state governments to provide affordable premiums to enrollees, the negative consequences include (again) the deadweight loss of taxation, as well as potential incentives for those without chronic conditions to forgo obtaining coverage until the need arises. Conceptually, the net financing under the high-risk pool arrangement is similar to the net financing under the community rating arrangement, but these two arrangements differ by whether there is an explicit tax to fund the high-risk pool or there is an implicit tax within the premium paid to cross-subsidize those with chronic health conditions.
A Market Arrangement Using Guaranteed Renewability and Equal Tax Treatment
There is a market-oriented arrangement that would provide affordable coverage for people with chronic health conditions without disincentivizing people who don’t have chronic health conditions from obtaining coverage in a voluntary, private market, and without an individual mandate that forces everyone to obtain coverage. To help illustrate this, return to the fundamental policy conundrum posed above: the challenge of achieving cross-subsidization from people without chronic conditions to people with chronic conditions. As noted above, a year-by-year, experience-rated premium would cause younger, healthy people to face the “risk of becoming high-risk” over a longer time horizon. In this situation, these younger, healthy people would want to insure against the uncertainty of being medically underwritten each year and paying high premiums if they have developed a chronic condition.
Guaranteed renewability in private health insurance markets can achieve this result of having people with and without chronic health conditions pay the same premiums—as long as people obtain insurance coverage before developing their first chronic health condition. How does this work? First, guaranteed-renewable insurance permits consumers to renew their coverage at the same premium, regardless of whether they have developed any new chronic health conditions since obtaining the insurance. Moreover, an “incentive compatible” schedule of premiums over time results in people without chronic health conditions actually purchasing coverage voluntarily rather than avoiding coverage because of adverse selection.
As several economists suggested in the mid-1990s, a guaranteed-renewable health insurance policy can be conceptualized as having two parts to the premium: one part covers the upcoming single year’s expected expenses for those without chronic conditions, while the second part covers the cumulative multiyear difference between expected spending with chronic conditions and without them for those who develop their first chronic condition within the upcoming year. As a result, the “subsidies” to cover the higher costs of people who develop chronic conditions simply come from the voluntarily purchased, long-term components of everyone’s premiums.
This long-term structure of premiums is similar to the system used in term life insurance, where insured individuals are protected against increases in premiums resulting from changes in their health status. Estimates of the “front loading” of premiums in the early years to enable lower premiums in later years (necessary to convince healthy older people to stay in the pool instead of exiting) are not so high, and thus an arguably affordable premium path over time can be achieved. While the ratio of underlying spending for 64-year-olds versus 18-year-olds is approximately five to one, incentive-compatible guaranteed renewability ultimately yields a ratio of premiums for 64-year-olds versus 18-year-olds estimated to be approximately three to one—ironically the same level specified for the ACA’s modified community rating.
One may ask what prevented a robust individual market with guaranteed renewability from achieving widespread pooling before the ACA. Interestingly, most individual market plans were indeed sold with this guaranteed-renewable provision,3 but the market was still characterized to a great extent by medical underwriting for new applicants with pre-existing conditions. The inequity of limiting tax subsidies to the employment-based market, coupled with the transitory nature of employment-based coverage as people move from job to job, is likely what led to the large number of middle-aged adults with chronic conditions seeking individual insurance for the first time (after losing their employment-based coverage).
Without this bias in the tax treatment of health insurance, these middle-aged adults with chronic conditions could have simply initiated their subsidized coverage in the individual market when young and healthy and maintained that coverage. Attempting to initiate individual coverage as a middle-aged adult with a chronic condition is problematic because, under guaranteed-renewable coverage, having people with chronic health conditions pay the same premium as people without chronic conditions requires that the former purchased (and maintained) that guaranteed-renewable coverage when healthy.
To sum up, providing equitable tax subsidies in an individual market with guaranteed renewability would likely result in a more robust health insurance market that would provide those who develop chronic conditions with continuous coverage at affordable premiums. Guaranteed-renewable insurance allows those with chronic health conditions to pay a pooled premium that is the same as that paid by those without chronic health conditions, but as a result of a voluntary decision to pool together rather than a regulatory requirement to do so.
Moreover, this market-oriented arrangement would not bring about the negative side effects associated with the regulatory arrangements, such as the deadweight loss of taxation, regulatory capture, or higher unemployment. That said, a transition to this market-oriented arrangement would likely have to be coupled with high-risk-pool coverage for those who already have pre-existing conditions, but the need for these high-risk pools would decline over time.