Insulation vs. Insurance

Question: How many American families have proper health insurance?

a) over 90 percent.

b) between 80 and 90 percent.

c) between 10 and 80 percent.

d) less than 10 percent.

Given that about 15 percent of American families do not have health insurance, the correct answer would appear to be (b). However, in my opinion, the correct answer is (d).

The health coverage most Americans have is what I call “insulation,” not insurance. Rather than insuring them against risk, most families’ health plans insulate them from paying for most health care bills, large and small.

Real insurance, such as fire insurance, provides protection against rare, severe risk. Real insurance is characterized by:

– low premiums

– infrequent claims

– large claims

American health insurance—including employer-provided insurance and Medicare—is the opposite. Families typically are paid claims several times per year, often for small amounts. Premiums are high—the cost of providing insulation often exceeds $10,000 per year per family. However, most families pay these premiums only indirectly, through taxes and reduced take-home pay from employers.

Real insurance would pay for treatments that are unavoidable, prohibitively expensive, or for illnesses that occur relatively rarely. Instead, insulation reimburses even relatively low-cost services, such as a test for strep throat or a new pair of eyeglasses. Insulation pays for treatment even if it is commonplace or discretionary.

What is Wrong with Insulation?

For health care providers, insulation is a bonanza. Because consumers are not spending their own money, they accept doctors’ recommendations for services without questioning them and without concern for cost. Faced with an insured patient, a health care provider is like a restaurant catering to convention-goers with unlimited expense accounts. The customer will gladly take the most high-end recommendation and not worry about the price.

Consumers are happy as well. Insulation relieves the patient of the stress of making decisions about treatment. The patient also does not have to worry about shopping around for the best price.

The problem with insulation is that it is not a sustainable form of health care finance. Individuals, employers, and government are all under stress.

Families that are in the individual insurance market face sticker shock when they confront health insurance premiums. Many choose to remain uninsured.

Employers are finding health care expenses an increasing burden. A noticeable gap has arisen in the past twenty years between the growth of total employee compensation and the growth of wages. Take-home pay is stagnant or shrinking, as much of the growth in compensation is diverted to health care.

Medicaid has become the largest item in many state budgets. Medicare is responsible for America’s biggest long-term fiscal crisis, with a looming gap between promised benefits and expected tax revenues rising to several percent of GDP per year in the middle of this century.

From an economic standpoint, insulation is both inefficient and inequitable. It allocates too many resources to health care, and it includes regressive subsidies that flow up the income scale.

Insulation leads people to over-consume health care services. Americans make extravagant use of services that have high costs and low benefits. Many studies that compare groups with similar conditions show that those with the largest levels of health care spending fare no better in terms of outcomes than those that spend less.

Insulation is also inefficient because of the large taxes that it requires. Payroll taxes support Medicare. Income taxes support Medicaid. Moreover, income tax rates are higher than they would be otherwise, because employer-provided health insurance is a deductible expense for companies but is not taxable income to employees. Taken together, higher payroll and income taxes to support insulation discourage work and thrift, leading to what economists call a “deadweight loss” to the economy.

Insulation also is inequitable. Millionaires on Medicare have their treatments paid for by taxes on low-income workers. High-income earners derive relatively more benefit than low-wage workers from the tax exemption of employer-provided insulation from health expenses.

We Have Had Insulation for Several Decades. Why Is It a Problem Now?

Today, over 85 percent of our health care spending is paid for by third parties—either private health insurance or government programs. America has one of the highest rates of insulation in the world.

At the same time, and partly in response to the bonanza provided by insulation, medical specialization and medical technology have surged. In my book, Crisis of Abundance, I call this phenomenon premium medicine. Primarily because of premium medicine, the share of our income devoted to health care in this country has roughly doubled over the past 30 years, from about 8 percent of GDP to about 16 percent of GDP.

Sometimes our skilled specialists and advanced technology make a difference for patients, extending lives and alleviating suffering. Often, however, services are provided that make no difference. The MRI exam that I had when I hurt my back moving furniture was pointless—the treatment would have been rest and anti-inflammatories, whatever the exam showed. My doctor’s referring me to a nephrologist for microscopic hematuria (blood in a urine specimen not visible to the naked eye) was equally pointless—like many people, I have this symptom sometimes, and then it mysteriously goes away.

We have accumulated a dazzling array of human and physical capital, and we are developing a culture that insists on using it to the fullest extent. The use of medical services well beyond the point of diminishing returns is what is driving up our health care costs and making it difficult to finance individual insurance, employer-provided insurance, and our government programs.

Can We Solve Our Health Care Crisis by Being More Efficient?

By definition, our health care system would be more efficient if we could deliver the same health care services at less cost. While greater efficiency is certainly possible and desirable, it would not relieve the stress in health care finance.

For example, pundits such as New York Times columnist Paul Krugman claim that private health insurance is inefficient due to overhead. However, even if one eliminated all of the overhead in health insurance, this would reduce total health care spending by about 1 percent of GDP, still leaving us spending 15 percent of our GDP on health care, about 5 percentage points more than most other countries.

Moreover, any gain in efficiency would not slow the growth of health care spending, which is driven by the ever-increasing supply of premium medicine in the context of unchecked demand. The only reliable way to slow the growth of health care spending is to slow the rate of increase in consumption of premium medicine. We cannot address the problems caused by the extravagant use of health care services that have high costs and low benefits by trimming the overhead expense involved in delivering these unnecessary services.

Other countries spend less of their GDP on health care, with little apparent difference in health outcomes. (Note, however, that the standard measure of health care outcomes—average longevity—is a flawed indicator, because it ignores many benefits of health care and does not take into account other factors that influence lifespan.) This is because premium medicine is less available in those countries, and the constraints on supply limit the extravagant use of procedures with high costs and low benefits. For example, the use of colonoscopy to screen for colon cancer in healthy patients over 50, as recommended in the United States, is not possible in Canada, due to the scarcity of equipment and trained personnel. Yet this may make relatively little difference in average longevity, because colon cancer tends to emerge late and to move slowly, so that many of its victims die of other illnesses first.

How Would Real Health Insurance Work?

Real health insurance would pay claims to people who come down with expensive illnesses. Typically, these expenses accumulate over a period of years.

In Crisis of Abundance, what I have suggested is a health insurance policy that you buy this year, but reimburses you in five years, based on cumulative expenses. Such a policy might pay nothing if your total expenses over the next five years are less than $30,000. It might pay 100 percent of expenses thereafter.

For example, if I buy a policy in January of 2007 and my expenses from 2007 to 2011 total $35,000, I would be reimbursed for $5000. The policy that I buy in January of 2008 would reimburse me based on expenses that I incur from 2008 to 2012, so that if my expenses for that period were $33,000, then I would be reimbursed for $3000.

These overlapping five-year policies would provide a better safety net than the annual policies that we have today. The typical catastrophic illness does not stop requiring treatment on December 31.

However, there are other ways to implement real health insurance that are worth considering. For example, one could have a health insurance policy where you make a claim when you are diagnosed with an expensive condition. First-stage breast cancer might result in a $25,000 payment. A heart condition requiring major surgery might result in a $40,000 payment. And so on. Only major medical problems would trigger claims, and payments would be for fixed amounts, not for reimbursement for procedures.

Real health insurance would not require high premiums. Fewer people would be discouraged from obtaining insurance by sticker shock.

It is not just private health insurance that needs to be changed if we are to move to real health insurance. Medicare would have to change as well. Instead of the insulation of Medicare, real health insurance for the elderly might be what I call “Remaining Lifetime Care Insurance.”

Between age 65 and death, medical expenses average a total of $100,000 per person. However, even if an individual saves $100,000 by age 65, the individual still needs protection against unusually large expenses. At age 65, you might keep $75,000 to pay for expenses out of pocket, and then spend $25,000 on an insurance policy with a remaining lifetime deductible of $75,000. That insurance policy only pays when the expenses that you accumulate after age 65 exceed $75,000. However, it guarantees that your out-of-pocket medical expenses will not exceed $75,000.

With these sorts of policies, individuals would be protected from extreme financial loss. However, they would be insulated from much less of their health care expenses than they are today. In fact, some simulations I performed using the government’s Medical Expenditure Panel Survey showed how it might be possible to increase the share of out-of-pocket spending from 15 percent to over 50 percent, while still providing a safety net to the very poor and the very sick.

Having individuals pay for more of their own health care would be more efficient. It would reduce the disincentives to work and thrift caused by the collectivization of health care spending. It would also make individuals less inclined to undergo procedures that have high costs and low benefits. Consumers also would have the incentive to engage in comparison shopping when they encounter outrageously high charges from providers.

Can Consumers Make Reasonable Health-Care Decisions?

One common objection to real health insurance is that it is too burdensome for individual consumers to make health care decisions based on costs and benefits. The argument is that if we switch from insulation to insurance, then consumers will make bad decisions.

Harvard University health care economist David Cutler, in a conversation with economists at Cato, made such a point. He said that consumers do not really differentiate between necessary and unnecessary health care. As a result, he predicts that if consumers have to pay for more health care out of pocket, they will cut back proportionately on both cost-effective and cost-ineffective health care. Wasteful spending will decline, but so will useful spending. Ultimately, consumers’ health will suffer.

My view is that the solution to this potential problem is better information for consumers. I have endorsed the idea of a commission, perhaps with government funding, to study medical protocols in order to provide guidelines for what is typically cost effective.

How Would We Get There Institutionally?

Many government policies favor insulation rather than real health insurance. Changing these policies would help to encourage a transition to real health insurance.

State laws concerning health insurance tend to encourage comprehensive insurance. Lobbyists push for laws requiring insurance to cover treatments. These might include eye care, dental care, or fertility treatments. Such laws or regulations are inconsistent with insurance that is designed to protect against catastrophic illness.

Federal and state tax laws allow individuals to “launder” their health expenses through their employers in the form of comprehensive health insurance. We should reform the current system, in which employer-provided health insurance is deductible to companies but not included in individual compensation. One approach would be to count employer-paid premiums as compensation, or to put a cap on the amount of employer-paid premiums that would be tax exempt.

For people under 65, government should provide a safety net that is consistent with real health insurance. People who cannot afford to pay for health care will require government support, even to obtain basic services. People who have already been diagnosed with expensive illnesses probably will need a government subsidy in order to obtain real health insurance. Perhaps what some economists have called “catastrophic reinsurance,” in which government would pay all expenses above, say, $50,000 in a year, would enable the very sick to obtain health private health insurance. In any event, apart from the very poor and the very sick, government need not be involved in paying for health care.

Ultimately, people over 65 should be paying for health care out of savings. This means that Medicare ought to be phased out. I have proposed doing so by gradually raising the age of eligibility for Medicare. The age would stay the same for people currently on the verge of becoming eligible. It would rise somewhat for people in their 40s and early 50s. It would be raised considerably more for people now in their 30s, and Medicare would be phased out altogether for people under age 30.

How Would We Get There Culturally?

Today it is fairly deeply ingrained with most Americans that health care services are something that you should not have to pay for yourself. Insulation is the norm, and real health insurance as I would define it is almost nonexistent.

Suppose that we were to remove the tax benefits and other institutional supports for insulation. It is by no means certain that what would emerge instead would be real health insurance.

It could be that if health insurance were relatively unregulated and unsubsidized, then many people would opt to do without health insurance. This raises the issue of people “free riding” by doing without health insurance while healthy and then turning to government assistance when illness or injury occurs. It is to address this free-rider problem that some analysts propose making health insurance mandatory. This is a controversial idea, not well received at Cato. In any event, it is very difficult to justify a mandate for insulation, rather than a mandate for something closer to real health insurance.

Ultimately, I think we are headed for a collision of cultural values. We prefer insulation to real insurance. We expect services to be readily available, without the supply limitations or waiting lists that exist in countries where government is responsible for more health care funding. And yet we are growing increasingly concerned over the expansion of health care spending that takes place in a system that lacks constraints on either supply or demand.

Real health insurance may not be popular now. But when Americans see that the providers of insulation, including Medicare, have to turn to the rationing of health care services in order to meet budgetary constraints, real health insurance may start to look like a good alternative.

Also from this issue

Lead Essay

  • In this month’s lead essay, Cato Institute adjunct scholar Arnold Kling draws from his book, Crisis of Abundance, to argue that the health coverage most Americans enjoy is not insurance at all, but what he calls “insulation.” “The problem with insulation,” Kling argues, “is that it is not a sustainable form of health care finance… Insulation leads people to over-consume health care services. Americans make extravagant use of services that have high costs and low benefits.” Kling explains how real health insurance would work, and how it would help solve the crisis in health care, and explores how we could transistion to a system over time institutionally and culturally in order to resolve the inconsistent demand for insulation and affordable, effective care.

Response Essays

  • According to health care strategist Matthew Holt, Arnold Kling is correct that consumer insulation from the costs of “premium medicine” is partly responsible for the rising cost of health care, but Holt dissents from Kling’s solution. Holt examines what he takes to be the three main strategies for dealing with “the insulation and overuse of medical care in the U.S.”: a nationalized “single payer system; a system of “managed competition”; and “individual consumer control of spending at the point of service.” Holt argues that the latter two options face deep problems, and that a nationalized single-payer system “is the likeliest outcome in perhaps a decade or so,” even it is not politically feasible at present. “Kling has provided a decent analysis,” Holt argues, “but has proposed a solution that both ignores the political and cultural realities of the health care system, and probably wouldn’t even work in theory.”

  • Clark C. Havighurst agrees with Kling’s “diagnosis of what’s wrong with health care” in the U.S. “as far as it goes.” Havighurst goes further and digs into the reasons the U.S. health system “has evolved into an entitlement program under which everyone expects nothing less than the very best that ‘modern medicine’ has to offer.” Havighurst lays the blame at the feet of the government’s choice to subsidize the purchase of health care by “excluding the cost of employer-sponsored coverage from employees’ taxable wages and income” and lucidly details three different mechanisms by which the tax subsidy insulates workers, consumers, and voters from the costs of health care. Havighurst proposes that “something approaching [liberals’] goal of universal health coverage could be achieved by ending the current tax subsidy and offering refundable tax credits of, say, $6000 to families that spend at least that amount in health plan premiums or contributions to a health savings account.”

  • Jonathan Cohn, a senior editor at the New Republic, agrees with Kling that our current health care system doesn’t function according to the widely understood principles of individual insurance, but he doubts we’d do better at fighting rising costs and maintaining quality if citizens with “real” insurance were free to take price into account in their choice of care. “We have precious little evidence to believe that people can distinguish good care from bad care,” Cohn writes. And the notion that consumer choices will improve over time is, according to Cohn, “a lovely idea, but one that seems highly dubious.” Cohn argues that we need a broader notion of insurance – social insurance – to shield people not only against unexpected illness and harm, but against “genetic and economic bad luck.” Cohn argues that many nations do just fine in managing the cost/quality tradeoffs inherent in a state-controlled system of universal coverage, and that Americans would be happy with such a system “if only they knew how those systems really worked.”